Investment Appraisal Relevant Cash flows, Taxation and Inflation Answers

Question 1
Money interest rate = (1 + Real interest rate) x (1 + inflation rate) - 1
= (1.1 x 1.03) 1 = 0.133
Therefore use the discount rate of 13%
Question 2
Year
0
1
2
3
4

Capital allowances
WDA
250,000 x 0.25 = 62,500
187,500 x 0.25 = 46,875
140,625 x 0.25 = 35,156
105,469 x 0.25 = 26,367
79,102 5,000 = 74,102
245,000
0
$
(250,000)

Investment
WDA
Residual value
Balancing allowance
After-tax cash flows (250,000)

1
$

Tax benefit
62,500 x 0.30 =
46,875 x 0.30 =
35,156 x 0.30 =
26,367 x 0.30 =
74,102 x 0.30 =
Years
2
$

3
$

18,750
14,063
10,547
7,910
22,231
73,771
4
$

18,750

14,063

10,547

7,910
5,000

18,750

14,063

10,547

12,910

5
$

22,231
22,231

Question 3. Queue & Co

a) Nominal discount rate using Fisher effect: 1.15 x 1.04 = 1.196 thus 20%
Year
1
2
3
4
5
$000
$000
$000
$000
$000
Sales (W2)
306
416
531
216
V.C. (W3)
124
170
219
90
Contribution
182
245
312
126
Fixed (W5)
26
28
29
30
Net cash flow 156
217
283
96
Tax
(47)
(65)
(85)
(29)
CAs
15
11
8
6
16
Disposal
0
0
0
10
0
After-tax
171
181
226
27
(13)
DF
0.833
0.694
0.579
0.482
0.402
PV
142
126
131
13
(5)
b) This gives a positive NPV i.e. PV 407,000 Investment 200,000 = NPV 207,000
The purchase of the machine is acceptable on financial grounds.

Workings
(W1) Year
Selling price
Increase %
Total

1
10.00
1.02
10.20

2
10.20
1.02
10.40

3
10.40
1.02
10.61

4
10.61
1.02
10.82

2
40,000
10.40
416,000

3
50,000
10.61
530,500

4
20,000
10.82
216,400

1
4.00
1.03
4.12

2
4.12
1.03
4.24

3
4.24
1.03
4.37

4
4.37
1.03
4.50

(W4) Year
Demand (units
V.C. ($/unit)
V.C. ($/year

1
30,000
4.12
123,600

2
40,000
4.24
169,600

3
50,000
4.37
218,500

4
20,000
4.50
90,000

(W5)
Fixed costs
Increase %

1
25,000
1.05
26,250

2
26,250
1.05
27,563

3
27,563
1.05
28,941

(W2) Year
1
Demand (units
30,000
Selling price ($/unit)
10.20
Sales ($/year)
306,000
(W3) Year
VC
Increase %

(W3) Year
0
1
2
3
4

Capital allowances
200,000 x 0.25 = 50,000
150,000 x 0.25 = 37,500
112,500 x 0.25 = 28,125
84,375 x 0.25 = 21,094
63,281 10,000 = 53,281
190,000

4
28,941
1.05
30,388

Tax benefit
50,000 x 0.3 = 15,000
37,500 x 0.3 = 11,250
28,125 x 0.3 = 8,438
21,094 x 0.3 = 6,328
53,281 x 0.3 = 15,984
57,000

c)
Total net cash flow before tax = 156 + 217 + 283 + 96 = $752,000
Total depreciation = 200,000 10,000 = $190,000
Average annual profits = (752 190)/4 = $140,500
Average investment = (200,000 + 10,000)/2 = $105,000
ROCE =140,500/105,000 x 100 = 134%
Target ROCE is 30% therefore the purchase of the machine is recommended

Question 4. Pew & Co

a) Nominal discount rate: 1.10 x 1.03 = 1.133 thus 13%
Year
1
2
3
$000
$000
$000
Sales (W2)
93
191
295
V.C. (W3)
31
65
101
Contribution
62
126
194
Fixed (W5)
32
33
35
Net cash flow
30
93
159
Tax
(12)
(37)
CAs
40
30
23
Disposal
After-tax
70
111
145
DF
0.885
0.783
0.693
PV
62
87
100

4
$000
203
70
133
36
97
(64)
17
100
150
0.613
92

5
$000

(39)
11
0
(28)
0.543
(15)

b) This gives a positive NPV i.e. PV 326,000 Investment 400,000 = NPV (74,000)
The purchase of the machine is not acceptable on financial grounds.
Workings
(W1) Year
Selling price
Increase %
Total

1
9.00
1.03
9.27

(W2) Year
Demand (units
Selling price ($/unit)
Sales ($/year)

2
9.27
1.03
9.55

3
9.55
1.03
9.84

1
10,000
9.27
92,700

2
20,000
9.55
191,000

3
30,000
9.84
295,200

4
20,000
10.14
202,800

1
3.00
1.04
3.12

2
3.12
1.04
3.24

3
3.24
1.04
3.37

4
3.37
1.04
3.50

(W4) Year
Demand (units
V.C. ($/unit)
V.C. ($/year

1
10,000
3.12
31,200

2
20,000
3.24
64,800

3
30,000
3.37
101,100

4
20,000
3.50
70,000

(W5)
Fixed costs
Increase %

1
30,000
1.05
31,500

2
31,500
1.05
33,075

3
33,075
1.05
34,729

4
34,729
1.05
36,465

(W3) Year
VC
Increase %

4
9.84
1.03
10.14

(W3) Year
0
1
2
3
4

Capital allowances
400,000 x 0.25 = 100,000
300,000 x 0.25 =
75,000
225,000 x 0.25 =
56,250
168,750 x 0.25 =
42,188
126,562 100,000 = 26,562
300,000

Tax benefit
100,000 x 0.4 =
75,000 x 0.4 =
56,250 x 0.4 =
42,188 x 0.4 =
26,562 x 0.4 =

40,000
30,000
22,500
16,875
10,625
120,000

c)
Total net cash flow before tax = 30 + 93 + 159 + 97 = $379,000
Total depreciation = 400,000 100,000 = $300,000
Average annual profits = (379 300)/4 = $19,750
Average investment = (400,000 + 100,000)/2 = $250,000
ROCE =19,750/250,000 x 100 = 6.58%
Target ROCE is 15% therefore the purchase of the machine is not recommended
Question 5. Tower & Co
(a) Calculation of net present value
Year
0
1
2
3
4
5
$
$
$
$
$
$
Sales
303,450
406,870
667,480
349,600
VC
(123,725)
(164,220)
( 266,770)
(138,320)
Contribution
179,725
242,650
400,710
211,280
Taxation
(44,931)
(60,663)
(100,178)
(52,820)
CAs
31,250
31,250
31,250
31,250

After-tax cash flow

210,975
228,969
371,297
142,352
(52,820)
Investment ( 500,000)
WC
(12,138) (4,137)
(10,424)
12,715
13,984


Net CF
(512,138) 206,838
218,545
384,012
156,336
(52,820)
DCF12%
1000
0893
0797
0712
0636
0.567

PV
(512,138) 184,706
174,180
273,417
99,430
(29,949)

NPV = $189,646

Workings
Sales revenue
Year
Selling price ($/unit)
Sales volume (units)
Sales revenue ($)

1
1734
17,500
303,450

Variable costs
Year
Variable cost ($/unit)
Sales volume (units)
Variable costs ($)

1
707
17,500
123,725

2
1769
23,000
406,870
2
714
23,000
164,220

Total investment in working capital

3
1804
37,000
667,480

4
1840
19,000
349,600

3
721
37,000
266,770

4
728
19,000
138,320

Year 0 investment = 303,450 x 0.04 = $12,138

Year 1 investment = 406,870 x 004 = $16,275
Year 2 investment = 667,480 x 004 = $26,699
Year 3 investment = 349,600 x 004 = $13,984
Incremental investment in working capital
Year 0 investment = 303,450 x 004 = $12,138
Year 1 investment = 16,275 12,138 = $4,137
Year 2 investment = 26,699 16,275 = $10,424
Year 3 recovery = 13,984 26,699 = $12,715
Year 4 recovery = $13,984
(b) Calculation of internal rate of return
Year
$
Net CF
Dis 20%
PV

0
$
(512,138)
1000

(512,138)

1
2
$
$
206,838 218,545
0833
0694

172,296 151,670

3
4
5
$
$
$
384,012 156,336
(52,820)
0579
0482
0.402

222,343 75,354
(21,233)

NPV at 20% = $88,392

NPV at 12% = $189,646
IRR = 12 + [(20 12) x 189,646/(189,646 - 88,392)] = 26.98%
(c) Acceptability of the proposed investment
1. The NPV is positive and so the proposed investment can be recommended
on financial grounds.
2. The IRR is greater than the discount rate used by Tower & Co for investment
appraisal purposes and so the proposed investment is financially acceptable.
3. The cash flows of the proposed investment are conventional and so there is
only one internal rate of return.
4. Only one proposed investment is being considered and so there is no conflict
between the advice offered by the IRR and NPV investment appraisal methods.
Limitations of the investment evaluations
1. Both the NPV and IRR evaluations are heavily dependent on the production and sales
volumes that have been forecast and so Tower & Co should investigate the key
assumptions underlying these forecast volumes. It is difficult to forecast the length and
features of a products life cycle so there is likely to be a degree of uncertainty
associated with the forecast sales volumes.
2. The inflation rates for selling price per unit and variable cost per unit have been
assumed to be constant in future periods. In reality, interaction between a range of
economic and other forces influencing selling price per unit and variable cost per unit
will lead to unanticipated changes in both of these project variables. The assumption of
constant inflation rates limits the accuracy of the investment evaluations and could be an
important consideration if the investment were only marginally acceptable.

3. Since no increase in fixed costs is expected because Tower & Co has spare capacity
in both space and labour terms, fixed costs are not relevant to the evaluation and have
been omitted. No information has been offered on whether the spare capacity exists in
future periods as well as in the current period. Since production of Zebra is expected to
more than double over three years, future capacity needs should be assessed before a
decision is made to proceed, in order to determine whether any future incremental fixed
costs may arise.
(d)
1. Shareholder wealth increases through a positive NPV on investments, receiving
dividends and through share prices increasing over time. Changes in share prices can
therefore be used to assess whether a financial management decision is of benefit to
shareholders. In fact, the objective of maximising the wealth of shareholders is usually
substituted by the objective of maximising the share price of a company.
2. The net present value (NPV) investment appraisal method advises that an investment
should be accepted if it has a positive NPV. If a company accepts an investment with a
positive NPV, the market value of the company, theoretically at least, increases by the
amount of the NPV. Shareholder wealth is therefore increased if positive NPV projects
are accepted and, again theoretically, shareholder wealth will be maximised if a
company invests in all projects with a positive NPV.
3. Negative NPVs will always be rejected as they erode shareholders wealth, a negative
NPV gives a return that is below the companys cost of capital.
4. The NPV is the most reliable measure of investment appraisal when compared to
ARR, Payback and IRR. All of these are subject to arbitrary management targets and
give no clear accept or reject decisions. NPV always gives the correct result and is not
subject to contradictory results as is the IRR
5. The NPV investment appraisal method also contributes towards the objective of
maximising the wealth of shareholders by using the cost of capital of a company as a
discount rate when calculating the present values of future cash flows. A positive
NPV represents an investment return that is greater than that required by a companys
providers of finance, offering the possibility of increased dividends being paid to
shareholders from future cash flows.
Question 6. Delphi & Co
(a) Net present value evaluation of investment
After-tax weighted average cost of capital = (18 x 075) + (8 x (1 025) x 025) = 15%
Year
1
2
3
4
5
$000
$000
$000
$000
$000
Contribution
260
325
390
390
Fixed costs
(120) (130)
(140)
(150)

Taxable cash flow
140
195
250
240
Taxation
(35)
(49)
(63) (60)
CA tax benefits
25
19
14
11
28
Scrap value
15

After-tax cash flows
165
179
215
203
(32)
Discount at 15%
0870 0756 0658 0572 0497

Present values
144
135
141
116
(16)

$000
520
400

120

Present value of benefits

Initial investment
Net present value

The net present value is positive and so the investment is financially acceptable.
However, demand becomes greater than production capacity in the fourth year
of operation and so further investment in new machinery may be needed after
three years.
The new machine will itself need replacing after four years if production
capacity is to be maintained at an increased level. It may be necessary to
include these expansion and replacement considerations for a more complete
appraisal of the proposed investment.
A more complete appraisal of the investment could address issues such as
the assumption of constant selling price and variable cost per kilogram and the
absence of any consideration of inflation, the linear increase in fixed costs of
production over time and the linear increase in demand over time.
If these issues are not addressed, the appraisal of investing in the new
machine is likely to possess a significant degree of uncertainty.
Workings
Annual contribution
Year
1
2
3
Excess demand (kg/yr)
200,000
250,000
300,000
New machine output (kg/yr) 200,000
250,000
300,000
Contribution ($/kg)
13
13
13

Contribution ($/yr)
260,000
325,000
390,000

Capital allowance (CA) tax benefits

Year
Capital allowance ($)
Tax benefit ($)
0
400,000 x 025
= 100,000 x 0.25
=
25,000
1
300,000 x 025
= 75,000 x 025
=
18,750
2
225,000 x 025
= 56,250 x 0.25
=
14,063
3
168,750 x 0.25
= 42,188 x 0.25
=
10,547
4
126,562 15,000
= 111,562 x 0.25
=
27,891
(b) Internal rate of return evaluation of investment
Year
After-tax cash flows
Discount at 20%
Present values

1
$000
165
0833

137

Present value of benefits

Initial investment
Net present value

2
$000
179
0694

124

3
$000
215
0579

125

4
$000
203
0482

98

$000
471
400
71

5
$000
(32)
0402

(13)

4
350,000
300,000
13

390,000

Internal rate of return = 15 + (120/(120 - 71) x 5) = 272%

The investment is financially acceptable since the internal rate of return is
greater than the cost of capital used for investment appraisal purposes.
However, the appraisal suffers from the limitations discussed in connection
with net present value appraisal in part (a).
(c) Risk refers to the situation where probabilities can be assigned to a range of
expected outcomes arising from an investment project and the likelihood of each
outcome occurring can therefore be quantified.
Uncertainty refers to the situation where probabilities cannot be assigned to expected
outcomes. Investment project risk therefore increases with increasing variability of
returns, while uncertainty increases with increasing project life.
The two terms are often used interchangeably in financial management, but the
distinction between them is a useful one.
Sensitivity analysis assesses how the net present value of an investment project is
affected by changes in project variables. Considering each project variable in turn, the
change in the variable required to make the net present value zero is determined, or
alternatively the change in net present value arising from a fixed change in the given
project variable.
In this way the key or critical project variables are determined.
However, sensitivity analysis does not assess the probability of changes in Project
variables and so is often dismissed as a way of incorporating risk into the investment
appraisal process.
Probability analysis refers to the assessment of the separate probabilities of a number of
specified outcomes of an investment project. For example, a range of expected market
conditions could be formulated and the probability of each market condition arising in
each of several future years could be assessed.
The net present values arising from combinations of future economic conditions could
then be assessed and linked to the joint probabilities of those combinations.
The expected net present value (ENPV) could be calculated, together with the
probability of the worst-case scenario and the probability of a negative net present value.
In this way, the downside risk of the investment could be determined and incorporated
into the investment decision.