Chapter 3 Investment Appraisals & Chapter 4 Asset Investment Decisions and Capital Rationing

Homework II (Deadline: 3-June-2023)

1. A project involves the immediate purchase of an item of plant costing $150,000. It would
generate annual cash flows of $38,400 for four years, starting in Year 1. The plant purchased would
have a scrap value of $20,000 in five years, when the project terminates. Determine the project's
ROCE using: (a) initial capital costs & (b) average capital investment.

2. A project will involve spending $1.8 million now. Annual cash flows from the project would be
$350,000. What is the expected payback period?

3. Calculate the payback period in years and months for the following project:
Year Cash Flow ($000)
0 (1,800)
1 400
2 500
3 600
4 700
5 800

4. Garfield Co is considering whether to enter into a new project. The machinery which would be
used to produce the goods for the contract was purchased seven years ago at a cost of $80,000, with
an estimated life of ten years. Depreciation is on a straight-line basis. The machinery has been idle
for some time, and if not used on this contract would be scrapped and sold immediately for an
estimated $5,000. After use on this contract, the machinery would have no value, and would have
to be dismantled and disposed of at a cost of $1,500. Ignoring the time value of money what is the
relevant cost of the machine to the new contract?

5. A potential project’s predicted cash flows give an NPV of $50,000 at a discount rate of 10% and
–$10,000 at a rate of 15%. Calculate the IRR.

6. A business undertakes high-risk investments and requires a minimum expected rate of return of 17%
per year on its investments. A proposed capital investment has the following expected cash flows:
Year Cash Flow ($)
0 (80,000)
1 15,000
2 24,000
3 9,000
4 16,000
(1) Calculate the NPV of the project if the cost of capital is 15%.
(2) Calculate the NPV of the project if the cost of capital is 20%.

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(3) Use the NPVs you have calculated to estimate the IRR of the project.
(4) Recommend, on financial grounds alone, whether this project should go ahead.

7. A business undertakes high-risk investments and requires a minimum expected rate of return of
17% per year on its investments. A proposed capital investment has the following expected cash
flows:

Year Cash Flow ($)

0 (50,000)
1 18,000
2 25,000
3 20,000
4 10,000

(1) Calculate the NPV of the project if the cost of capital is 15%.
(2) Calculate the NPV of the project if the cost of capital is 20%.
(3) Use the NPVs you have calculated to estimate the IRR of the project.
(4) Recommend, on financial grounds alone, whether this project should go ahead.

8. Arbury Co has made an investment with a net present value (NPV) of $42,000 at 10% and an
NPV of ($22,000) at 20%. What is the internal rate of return of the project?

9. An asset is bought for $15,000 and will be used on a project for five years after which it will be
disposed of. Tax is payable at 20%, one year in arrears, and tax-allowable depreciation is available
at 25% reducing balance.
(a) Calculate the tax-allowable depreciation and hence the tax savings for each year if the proceeds
on disposal of the asset are $2,500.
(b) How would your answer change if the asset were sold for $7,000?
(c) If net trading income from the project is $9,500 per year, based on your answer to part (a) and
a cost of capital of 12%, calculate the NPV of the project.

10. A company expects sales for a new project to be $250,000 in the first year growing at 4% per
year. The project is expected to last for 5 years. Working capital equal to 9% of annual sales is
required and needs to be in place at the start of each year. Calculate the working capital flows for
incorporation into the NPV calculation.

11. A company anticipates sales for the latest venture to be 150,000 units per year. The selling price
is expected to be $4 per unit in the first year, inflating by 9% per year over the four-year life of the
project. Working capital equal to 10% of annual sales is required and needs to be in place at the start
of each year. Calculate the working capital cash flows for incorporation into the NPV calculation.

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12. Ackbono Co is considering a potential project with the following forecasts:
Now T1 T2 T3
Initial investment ($million) (1,500)
Disposal proceeds ($million) 150
Demand (millions of units) 5 12 8

The selling price per unit is expected to be $100 and the variable cost $30 per unit. Both of these
figures are given in today’s terms. Tax is paid at 30%, one year after the accounting period
concerned. Working capital will be required equal to 10% of annual sales. This will need to be in
place at the start of each year. Tax-allowable depreciation is available at 25% reducing balance.
The company has a real required rate of return of 6.8%. General inflation is predicted to be 3% per
year but the selling price is expected to inflate at 4% and variable costs by 5% per year Determine
the NPV of the project. N.B. work in $ millions and round all numbers to the nearest whole million.

13. Walshey Co has already decided to accept a project and is now considering how to finance it.
The asset could be leased over four years at a rental of $54,000 per year, payable at the start of each
year. Tax is payable at 25%, one year in arrears. The post-tax cost of borrowing is 12%. Calculate
the net present value of the leasing option.

14. A firm has decided to acquire a new machine to neutralise the toxic waste produced by its
refining plant. The machine would cost $8 million and would have an economic life of six years.
Tax-allowable depreciation of 20% per year on a reducing balance basis is available for the
investment. Taxation of 35% is payable on operating cash flows, one year in arrears. The firm
intends to finance the new plant by means of a six-year fixed interest loan at a pre-tax cost of 12%
per year, with the principal repayable in six years’ time. As an alternative, a leasing company has
proposed a lease over six years at $1.5 million per year payable in advance. Scrap value of the
machine under each financing alternative will be zero. Evaluate the two options for acquiring the
machine and advise the company on the best alternative.

15. A machine costs $40,000. The following information is also available:

Running costs (payable at the end of the year):
Year 1 $8,000
Year 2 $9,000
Trade-in allowance
Disposal after 1 year $18,000
Disposal after 2 years $15,000

Calculate the optimal replacement cycle if the cost of capital is 10%.

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16. A decision has to be made on replacement policy for vans. A van costs $15,000 and the
following additional information applies:
Asset sold at Trade-in Asset Maintenance cost at end
end of year allowance Kept for of year
1 $10,000 1 year 0
2 $8,500 2 years $1,500 in 1st year
3 $6,000 3 years $2,700 in 2nd year

Calculate the optimal replacement policy at a cost of capital of 15%. Note that the asset is only
maintained at the end of the year if it is to be kept for a further year, i.e. there are no maintenance
costs in the year of replacement. Ignore taxation and inflation.

17. A company has $200,000 available for investment and has identified the following 5
investments in which to invest. All investments must be started now (Yr 0).
Project Initial investment (Yr 0) NPV
A $50,000 $20,000
B $120,000 $40,000
C $60,000 $28,000
D $50,000 $15,000
E $60,000 ($10,000)

Determine which projects should be chosen to maximise the return to the business.

18. The company from TYU5 has the same problem as before but this time the projects are
indivisible. The information is reproduced below:
A company has $150,000 available for investment and has identified the following 5 investments in
which to invest. All investments must be started now (Yr 0). Determine the optimal project selection.

Project Initial investment (Yr 0) NPV

A $50,000 $20,000
B $120,000 $40,000
C $60,000 $28,000
D $50,000 $15,000
E $60,000 ($10,000)