Question 1

TZ Limited

(i) Equipment X
Capital cost $80,000
Life 5Years
Profits before depreciation $
Year 1 50,000
2 50,000
3 30,000
4 20,000
5 10,000

Disposal value Nil

Solution

Calculation of depreciation using the common depreciation method- the straight line depreciation

Depreciation expense = (cost – scrape value) useful life

Depreciation = ($80,000 - $80) 5years = $16,000

Year 1 2 3 4 5
Cash flow ($) 50,000 50,000 30,000 20,000 10,000
Depreciation ($) 16,000 (16,000) (16,000) (16,000) (16,000)
Accounting income ($) 34,000 34,000 14,000 4,000 (6,000)

Average income ($) = [(34,000+ 34,000 +14,000 + 4,000) - 6,000]

= 80,000÷ 5years = 16,000 = 20%
80,000 80,000

(ii) Equipment Y
Capital cost $150,000
Life 5Years
Profits before depreciation $
Year 1 50,000
2 50,000
3 60,000
4 60,000
5 60,000

Disposal value Nil

Solution

Depreciation expense = (Initial cost – Scrape Value) ÷ Life Years

Depreciation = ($150,000 - $50) ÷ 5years
Depreciation per year = $150,000 = $30,000
5
Year 1 2 3 4 5
Cash flow ($) 50,000 50,000 60,000 60,000 60,000
Depreciation ($) (30,000) (30,000) (30,000) (30,000) (30,000)
Accounting income ($) 20,000 20,000 30,000 30,000 30,000

Average income ($) = (20,000+ 20,000 +30,000 + 30,000 + 30,000)

= 130,000÷ 5years = 26,000 = 17.3%
150,000 150,000
Investment decision
Target ARR = 15%
Equipment X = 20%
Equipment X = 17.3%

Management’s target ARR of 15% is proven to be lower compared to both ARR of equipment X

(20%) and ARR of equipment Y (17.3%). This gives an indication to management to accept the

proposal for both equipments X and Y. However, against the two equipments, equipment X

comes out to be more favourable than equipment Y. Indicating that it has higher capacity and

greater reliability, so equipment X would be picked as the best followed by Y and last the

targeted.

ARR (Average Rate of Return) is also known as Account Rate of Return, ARR is the average net

income an asset is expected to generate divided by its average capital cost, expressed as a

percentage (%). ARR is a formula used to make capital budgeting decisions, this typically

include situations where companies are deciding on whether or not to proceed with specific

investment (a project or an acquisition etc). ARR though helpful in determining the annual

percentage (%) rate of return of a project, its calculations has limitations (ACCA F9, 2016).
Drawbacks of ARR Method of capital investment appraisal

ARR method of capital investment appraisal has serious drawbacks that it does not take into

account of the timing of the profits from an investment. According to (ACCA F9, 2016)

whenever capital is invested in a project, money is tied up until the project begins to earn profits

which payback the investment. Money tied up in one project cannot be invested anywhere else

until the profits come in. Management should be aware of the benefits of early repayments from

an investment which provide money for other investments. In addition to this there are a number

of other drawbacks of ARR method as follows:-

1. It is based on accounting profits and not cash flows. Accounting profits are subject to a

number of different accounting treatments e.g. the depreciation charge per year, and many

other expenses that may need to be subtracted.

2. It is a relative measure rather than absolute measure and therefore takes no account of the

size of the investment.

3. The method does not consider life period of the various investments but average earnings is

calculated by taking life period of the investment as a result initial investment may remain

the same even when the investment has life period of four (4) years or six (6) years.

4. ARR method ignores the investment potential of the project. The method cannot be used to

evaluate the projects where investment is made at different times.

5. It ignores the period in which the profits are earned, e.g. a 20% rate of return in ten (10) years

may be considered to be better than 18% rate of return for six (6) years. This is not proper

because the longer the term of the project, the greater the risk.

6. Different methods are used for accounting profits, so it leads to some difficulties in the

calculation of the project.

Calculation of Payback Period

Like ARR, Payback Period is also one of the traditional methods (or non-discount method) used

in capital budget evaluation. Paramasiva (2019) explains payback period as the time required to

recover the initial investment in a project.

Payback Period = Initial Investment

Annual Cash inflow

TZ Limited

(i) Equipment X
Capital cost $80,000
Life 5Years
Profits before depreciation $
Year 1 50,000
2 50,000
3 30,000
4 20,000
5 10,000

Solution

Capital cost = $80,000

Year Cash inflow ($) Cumulative
cash inflows ($)
1 50,000 50,000
2 50,000 100,000
3 30,000 130,000
4 20,000 150,000
5 10,000 160,000

The above calculation shows that in one (1) year, $50,000 has been recovered. $30,000 is the

balance out of cash outflows.

Pay-back period = 1 year + 30,000 x 12 months

50,000
= 1 year 7.2 months

= 1 year 7 months approximately

(ii) Equipment Y
Capital cost $150,000
Life 5Years
Profits before depreciation $
Year 1 50,000
2 50,000
3 60,000
4 60,000
5 60,000

Solution

Capital cost = $150,000

Year Cash inflow ($) Cumulative
cash inflows ($)
1 50,000 50,000
2 50,000 100,000
3 60,000 160,000
4 60,000 220,000
5 60,000 280,000

The above calculation shows that in two (2) years $100,000 has been recovered, $50,000 is the

balance out of cash outflows. In the 3 rd year the cash inflow is $60,000. It means the payback

period is two (2) to three (3) years and payback is calculated as follows:-

Pay-back period = 2 years + 50,000 x 12 months

60,000
= 2 years 10 months

However, the return from equipment Y over the life is higher than the return from equipment X.

Equipment X will earn total profits before depreciated of $80,000 on an investment of $80,000.

Equipment Y will earn total profit before tax of $130,000 on an asset of $150,000.

Accept/Reject Criteria

Project X is a better investment because it has a shorter payback period of one (1) year 7 months
compared to project Y with a payback period of two (2) years ten (10) months. A shorter
payback period is better because as situation suggests in case of equipment X, by the end of the
one (1) year seven (7) months it would have been paid off for itself. Also in terms of profitability
it would have gained a 100% profit of $80,000 i.e. profit before depreciation.

If a company can quickly recover from its investment, it would be easy for management to meet
its obligations even other operations would be possible because the company has enough
liquidity.

Advantages of the payback period

The following are the important advantages of the payback period:-

1. It is easy to understand and therefore simple to calculate

2. Payback period method uses cash flow instead of accounting profits

3. Payback period can be used by management to screen and eliminate obvious inappropriate
progress. This would show that management is focused on achieving the objectives.

4. Accept/reject criteria of accepting the project with shorter payback period helps company to
minimize financials and business risk

5. Payback period method can be used when there is a capital rationing situation to identify
those which generate additional cash for investment quickly.

Disadvantages of the payback period

1. It ignores the time value of money which means that it does not take account of the fact that
$1 in one year’s time.

2. It ignores all cash inflows after the payback period

3. Payback is not able to distinguish between projects with the same payback period

4. It may lead to excessive investment in short-term projects

5. It is one of the misleading evaluation of capital budgeting

REFERENCE

1. Wikipedia, the encyclopedia. Accounting rate of return

https//en.wikipedia.org/wiki/accounting_rate _of _return

2. Paramasiva.c.2009 financial management. new age international (p) ltd. Publisher New Delhi
www.newage publisher.com

3. ACCA – F9 2016, financial management study text 2016 9 th Edition Bpp learningmedia ltd
London
Question 2

PMT Limited

Introduction

Question two basically concern measuring the cost of capital. The methods of measuring cost of
capital are:-Cost of debt capital, Cost of preference capital, Cost of equity capital, Cost of
retained earnings, Weighted average cost of capital and Marginal cost of capital.

In economics and accountancy, the cost of capital is the cost of a company’s fund (both debt and
equity), or from an investor’s point of view the required rate of return on a portfolio company’s
existing securities (wikipedia.org). It is used to evaluate new projects of a company.

PMT Capital is composed of:

(i) Debt: which comes in form of long term debt and current liabilities
Long term liabilities $120,000
Current liabilities $50,000
$170,000

(ii) Equity: which comes in form of common stock and preferred stock
Common Stock $160,000
Preferred stock $90,000
$250,000

∴ To capital = Debt + Equity

= $170,000 + $250,000
= $420,000
(iii) ∴ Debt = 170,000 x 100 = 40%
420,000

Equity = 250,000 x 100 = 59.5% or 60% approximately

420,000

(iv) Cost of Equity

Re = (DI/PO) + g where:-
Re =? Re = Cost of equity
DI = $0.18 DI = Dividends
PO = $0.60 PO = Current share price
g = Dividends growth rate
∴ Re = (0.18÷ 0.6) + g
= 0.3x100
= 30%
(v) Expected Return on asset (use CAPM formula)

E (RI) = Rf + βI x E[(Rm) – Rf]

Where:-

E (RI) = Expected return on asset

Rf = Risk free rate on return
βI = Beta asset
E (Rm) = Expected market return
E [(Rm) – Rf] = Market risk premium

∴ E (RI) = ?, Rf = 15%, βI = 1.20, E [(Rm) = 22%

E (RI) = Rf + βI x E[(Rm) – Rf]

E (RI) = 15%+1.2 x [22-15]
= 0.15+0.084
= 0.234 x 100
= 23.4%

Weighted Average Cost of capital (WACC)

WACC = D/V (Rd) (1-T) + E/V (Re)

Where:-

D = Company’s debt
E = Company’s equity
V = Total market value of the company (E +D)
Re = Cost of equity
Rd = Cost of debt
T = Tax

WACC = (40%) (28)(1-40%) + (60%) (30%)

= (0.4) (0.28) (1-0.4) + (0.6) (0.3)
= (0.4) (0.28) (1-0.4) + (0.6) (0.3)
= (0.4) (0.28) (0.6) + (0.6) (0.3)
= 0.0672 + 0.18

∴ WACC = 1.21%
Why companies make bonus issues and stock split.

Kaplan J (2017) reviewed on reasons why some companies make bonus issues and stock split.
Companies low on cash may issue bonus shares rather than cash dividends as a method of
providing income to shareholders. Because issuing bonus shares increase the issued share capital
of the company, the company is perceived as being bigger than it really is, making it more
attractive to investors. Often when a company announces for a bonus issue or a stock split, they
look the same and one cannot understand the difference. Ideally they are issued to increase the
number of shares held by the investors.

Although they appear to be the same, (Aganwa, 2007) indicates the fundamental difference
between the two.

Bonus Issue

When the company issue bonus shares, there is an increase in the company’s share capital. The
increase in share capital is funded by the company reserves and surplus or retained earnings in
the balance sheet. Bonus is treated as a company reward to the equity investor of the company. A
bonus issue reflects management’s confidence in the future and gives a very strong signal in the
market.

Stock Split

Stock split is an issue of new shares in a company to existing shareholders in proportion to

current holdings. A stock split divides one share of stock into two or more shares. According to
(Shiern, 2017), the normal reason to split a stock is to increase the liquidity of stock for trading.
The exercise reduces the votality of the stock prices which benefits the shareholders in the long
run. Stock split also in a way is not good. Sometimes retail investors are not so savvy when the
stock split, and the share price is halved, the retail investor panic and rush to sell, while the
company can do cheaper share buyback or an insider to buy the shares cheaply.

REFERENCES

Wikipedia-cost of capital. https:// Wikipedia, org/wiki/cost_of_capital [24/02/2019]

Cost of equity-formula, guide, how to calculate the cost equity. https:// corporate financial
instruction.com/resources/knowledge/finance/cost of equity-guides

Kegan Julia, 2017-Bonus issue https://www.investopedia.com/terms/b/bonusissues.asp.

Agwawa vikas, 2017 –Bonus issue and stock splits- the economic times. https://ecomic
times.Indiatimes.com/bonus-issue-and-stick-split 25/15984 CMS