investment appraisal relevant cash flows answers

8/13/2019 Investment Appraisal Relevant Cash Flows Answers

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Investment Appraisal Relevant Cash flows, Taxation and Inflation AnswersQuestion 1

Money interest rate = 1 ! Real interest rate" x 1 ! inflation rate" # 1

= 1$1 x 1$%&" 1 = %$1&&Therefore use the dis'ount rate of 1&(

Question )Year Capital allowances Tax benefit

WDA% )*%,%%% x %$)* = +),*%% +),*%% x %$&% = 1,-*%1 1-,*%% x %$)* = .+,-* .+,-* x %$&% = 1.,%+&) 1.%,+)* x %$)* = &*,1*+ &*,1*+ x %$&% = 1%,*.-& 1%*,.+/ x %$)* = )+,&+- )+,&+- x %$&% = -,/1%. -/,1%) *,%%% = -.,1%) -.,1%) x %$&% = )),)&1

).*,%%% -&,--1

Years

% 1 ) & . *

0 0 0 0 0 0Investment )*%,%%%"2A 1,-*% 1.,%+& 1%,*.- -,/1%Residual value *,%%%3alan'in4 allowan'e )),)&1

After#tax 'ash flows )*%,%%%" 1,-*% 1.,%+& 1%,*.- 1),/1% )),)&1

Question &$ Queue 5 Coa" 6ominal dis'ount rate usin4 7isher effe't8 1$1* x 1$%. = 1$1/+ thus )%(

Year 1 2 3 4 5$000 $000 $000 $000 $000

9ales )" &%+ .1+ *&1 )1+

:$C$ &" 1). 1-% )1/ /%Contri;ution 1) ).* &1) 1)+7ixed *" )+ ) )/ &%6et 'ash flow 1*+ )1- )& /+Tax .-" +*" *" )/"CA


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or>in4s1"Year 1 2 3 49ellin4 pri'e 1%$%% 1%$)% 1%$.% 1%$+1In'rease ( 1$%) 1$%) 1$%) 1$%)Total 1%$)% 1%$.% 1%$+1 1%$)

)"Year 1 2 3 42emand units &%,%%% .%,%%% *%,%%% )%,%%%9ellin4 pri'e 0?unit" 1%$)% 1%$.% 1%$+1 1%$)9ales 0?year" &%+,%%% .1+,%%% *&%,*%% )1+,.%%

&"Year 1 2 3 4:C .$%% .$1) .$). .$&-In'rease ( 1$%& 1$%& 1$%& 1$%&

.$1) .$). .$&- .$*%

."Year 1 2 3 42emand units &%,%%% .%,%%% *%,%%% )%,%%%

:$C$ 0?unit" .$1) .$). .$&- .$*%:$C$ 0?year 1)&,+%% 1+/,+%% )1,*%% /%,%%%

*" 1 2 3 47ixed 'osts )*,%%% )+,)*% )-,*+& ),/.1In'rease ( 1$%* 1$%* 1$%* 1$%*

)+,)*% )-,*+& ),/.1 &%,&

&"Year Capital allowances Tax benefit% )%%,%%% x %$)* = *%,%%% *%,%%% x %$& = 1*,%%%1 1*%,%%% x %$)* = &-,*%% &-,*%% x %$& = 11,)*%) 11),*%% x %$)* = ),1)* ),1)* x %$& = ,.&

& .,&-* x %$)* = )1,%/. )1,%/. x %$& = +,&). +&,)1 1%,%%% = *&,)1 *&,)1 x %$& = 1*,/.

1/%,%%% *-,%%%

'"Total net 'ash flow ;efore tax = 1*+ ! )1- ! )& ! /+ = 0-*),%%%Total depre'iation = )%%,%%% 1%,%%% = 01/%,%%%

Avera4e annual profits = -*) 1/%"?. = 01.%,*%%Avera4e investment = )%%,%%% ! 1%,%%%"?) = 01%*,%%%R@C =1.%,*%%?1%*,%%% x 1%% = 1&.(Tar4et R@C is &%( therefore the pur'hase of the ma'hine is re'ommended

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Question .$ ew 5 Coa" 6ominal dis'ount rate8 1$1% x 1$%& = 1$1&& thus 1&(

Year 1 2 3 4 5$000 $000 $000 $000 $000

9ales )" /& 1/1 )/* )%&:$C$ &" &1 +* 1%1 -%

Contri;ution +) 1)+ 1/. 1&&7ixed *" &) && &* &+6et 'ash flow &% /& 1*/ /-Tax 1)" &-" +." &/"CA


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Bear % investment = &%&,.*% x %$%. = 01),1&Bear 1 investment = .%+,-% x %%. = 01+,)-*Bear ) investment = ++-,.% x %%. = 0)+,+//Bear & investment = &./,+%% x %%. = 01&,/.

In'remental investment in wor>in4 'apital

Bear % investment = &%&,.*% x %%. = 01),1&Bear 1 investment = 1+,)-* 1),1& = 0.,1&-Bear ) investment = )+,+// 1+,)-* = 01%,.).Bear & re'overy = 1&,/. )+,+// = 01),-1*Bear . re'overy = 01&,/.

(b) Cal'ulation of internal rate of returnBear % 1 ) & . *0 0 0 0 0 0 06et C7 *1),1&" )%+,& )1,*.* &.,%1) 1*+,&&+ *),)%"2is )%( 1%%% %&& %+/. %*-/ %.) %$.%)

: *1),1&" 1-),)/+ 1*1,+-% ))),&.& -*,&*. )1,)&&" 6: at )%( = 0,&/)6: at 1)( = 01/,+.+IRR = 1) ! D)% 1)" x 1/,+.+?1/,+.+ # ,&/)"E = )+$/(

(c)A''epta;ility of the proposed investment1$ The 6: is positive and so the proposed investment 'an ;e re'ommendedon finan'ial 4rounds$)$ The IRR is 4reater than the dis'ount rate used ;y Tower 5 Co for investmentappraisal purposes and so the proposed investment is finan'ially a''epta;le$&$ The 'ash flows of the proposed investment are 'onventional and so there is

only one internal rate of return$.$ @nly one proposed investment is ;ein4 'onsidered and so there is no 'onfli't;etween the advi'e offered ;y the IRR and 6: investment appraisal methods$

Fimitations of the investment evaluations1$ 3oth the 6: and IRR evaluations are heavily dependent on the produ'tion and salesvolumes that have ;een fore'ast and so Tower 5 Co should investi4ate the >eyassumptions underlyin4 these fore'ast volumes$ It is diffi'ult to fore'ast the len4th andfeatures of a produ'tely to ;e a de4ree of un'ertaintyasso'iated with the fore'ast sales volumes$

)$ The inflation rates for sellin4 pri'e per unit and varia;le 'ost per unit have ;een

assumed to ;e 'onstant in future periods$ In reality, intera'tion ;etween a ran4e ofe'onomi' and other for'es influen'in4 sellin4 pri'e per unit and varia;le 'ost per unitwill lead to unanti'ipated 'han4es in ;oth of these proGe't varia;les$ The assumption of'onstant inflation rates limits the a''ura'y of the investment evaluations and 'ould ;e animportant 'onsideration if the investment were only mar4inally a''epta;le$

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&$ 9in'e no in'rease in fixed 'osts is expe'ted ;e'ause Tower 5 Co has spare 'apa'ityin ;oth spa'e and la;our terms, fixed 'osts are not relevant to the evaluation and have;een omitted$ 6o information has ;een offered on whether the spare 'apa'ity exists infuture periods as well as in the 'urrent period$ 9in'e produ'tion of He;ra is expe'ted tomore than dou;le over three years, future 'apa'ity needs should ;e assessed ;efore ade'ision is made to pro'eed, in order to determine whether any future in'remental fixed

'osts may arise$

()1$ 9hareholder wealth in'reases throu4h a positive 6: on investments, re'eivin4dividends and throu4h share pri'es in'reasin4 over time$ Chan4es in share pri'es 'antherefore ;e used to assess whether a finan'ial mana4ement de'ision is of ;enefit toshareholders$ In fa't, the o;Ge'tive of maximisin4 the wealth of shareholders is usuallysu;stituted ;y the o;Ge'tive of maximisin4 the share pri'e of a 'ompany$)$ The net present value 6:" investment appraisal method advises that an investmentshould ;e a''epted if it has a positive 6:$ If a 'ompany a''epts an investment with apositive 6:, the mar>et value of the 'ompany, theoreti'ally at least, in'reases ;y theamount of the 6:$ 9hareholder wealth is therefore in'reased if positive 6: proGe'ts

are a''epted and, a4ain theoreti'ally, shareholder wealth will ;e maximised if a'ompany invests in all proGe'ts with a positive 6:$

&$ 6e4ative 6:


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0%%%resent value of ;enefits *)%Initial investment .%%

6et present value 1)%

The net present value is positive and so the investment is finan'ially a''epta;le$

Jowever, demand ;e'omes 4reater than produ'tion 'apa'ity in the fourth yearof operation and so further investment in new ma'hinery may ;e needed afterthree years$

The new ma'hine will itself need repla'in4 after four years if produ'tion'apa'ity is to ;e maintained at an in'reased level$ It may ;e ne'essary toin'lude these expansion and repla'ement 'onsiderations for a more 'ompleteappraisal of the proposed investment$

A more 'omplete appraisal of the investment 'ould address issues su'h asthe assumption of 'onstant sellin4 pri'e and varia;le 'ost per >ilo4ram and thea;sen'e of any 'onsideration of inflation, the linear in'rease in fixed 'osts ofprodu'tion over time and the linear in'rease in demand over time$

If these issues are not addressed, the appraisal of investin4 in the newma'hine is li>ely to possess a si4nifi'ant de4ree of un'ertainty$

or>in4sAnnual 'ontri;utionBear 1 ) & .x'ess demand >4?yr" )%%,%%% )*%,%%% &%%,%%% &*%,%%%6ew ma'hine output >4?yr" )%%,%%% )*%,%%% &%%,%%% &%%,%%%Contri;ution 0?>4" 1& 1& 1& 1&

Contri;ution 0?yr" )+%,%%% &)*,%%% &/%,%%% &/%,%%%

Capital allowan'e CA" tax ;enefitsBear Capital allowan'e 0" Tax ;enefit 0"% .%%,%%% x %)* = 1%%,%%% x %$)* = )*,%%%1 &%%,%%% x %)* = -*,%%% x %)* = 1,-*%) ))*,%%% x %)* = *+,)*% x %$)* = 1.,%+&& 1+,-*% x %$)* = .),1 x %$)* = 1%,*.-. 1)+,*+) 1*,%%% = 111,*+) x %$)* = )-,/1

(b) Internal rate of return evaluation of investmentBear 1 ) & . *

0%%% 0%%% 0%%% 0%%% 0%%%After#tax 'ash flows 1+* 1-/ )1* )%& &)"

2is'ount at )%( %&& %+/. %*-/ %.) %.%)

resent values 1&- 1). 1)* / 1&"

0%%%resent value of ;enefits .-1Initial investment .%%6et present value -1

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investment appraisal relevant cash flows answers

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