Download Chapter 4 DCF with Inflation and Taxation

Chapter 5 DCF with Inflation and Taxation
SYLLABUS
1.
2.
3.
Apply and discuss the real-terms and nominal-terms approaches to investment
appraisal.
Calculate the taxation effects of relevant cash flows, including the tax benefits of
capital allowances and the tax liabilities of taxable profit.
Calculate and apply before- and after-tax discount rates.
DCF with
Inflation
and
Taxation
Inflation
Specific
Inflation
General
Inflation
Interest
Rate
Real
Interest
Rate
Taxation
Money
Interest
Rate
Fisher's
Equation
P. 94
Capital
Allowances
Incorporating
Working
Capital
1.
Inflation
(Pilot, Jun 08, Jun 09, Dec 10, Jun 11, Jun 12, Dec 12, Jun 13, Dec 13, Jun 14, Dec 14)
1.1
Specific and general inflation
1.1.1 It is important to adapt investment appraisal methods to cope with the phenomenon of
price movement. Future rates of inflation are unlikely to be precisely forecasted;
nevertheless, we will assume in the analysis that follows that we can anticipate
inflation with reasonable accuracy.
1.1.2 Two types of inflation can be distinguished.
(a)
Specific inflation refers to the price changes of an individual good or
service.
(b)
General inflation is the reduced purchasing power of money and is
measured by an overall price index which follows the price changes of a
‘basket’ of goods and services through time.
Even if there was no general inflation, specific items and sectors might experience
price rises.
P. 95
1.1.3 Inflation creates two problems for project appraisal.
1.2
(a)
The estimation of future cash flows is made more troublesome. The project
appraiser will have to estimate the degree to which future cash flows will be
inflated.
(b)
The rate of return required by the firm’s security holders, such as
shareholders, will rise if inflation rises. Thus, inflation has an impact on the
discount rate used in investment evaluation.
Real and money interest rate
(Pilot, Jun 10, Dec 13)
1.2.1 The money (nominal or market) interest rate incorporates inflation. When the nominal
rate of interest is higher than the rate of inflation, there is a positive real rate. When
the rate of inflation is higher than the nominal rate of interest, the real rate of interest
will be negative.
1.2.2
Fisher’s (1930) Equation
The generalized relationship between real rates of interest and nominal rate of
interest is expressed as follow under Fisher’s equation:
(1 + i) = (1 + r) (1 + h)
Where h = inflation rate
r = real interest rate
i = nominal interest rate
1.2.3
EXAMPLE 1
$1,000 is invested in an account that pays 10% interest pa. Inflation is currently 7%
pa. Find the real return on the investment.
Solution:
Real return = $1,000 × 1.1/1.07 = $1.028. A return of 2.8%.
P. 96
1.2.4
Test your understanding 1
If the real rate of interest is 8% and the rate of inflation is 5%, what should the
money rate of interest be?
Solution:
1.3
Money cash flows and real cash flows
(Jun 13, Dec 13)
1.3.1 We have now established two possible discount rates, the money discount rate and
the real discount rate. There are two alternative ways of adjusting for the effect of
future inflation on cash flows.
(a)
(b)
The first is to estimate the likely specific inflation rates for each of the
inflows and outflows of cash and calculate the actual monetary amount paid
or received in the year that the flow occurs. This is the money (nominal) cash
flow.
The other possibility is to measure the cash flows in terms of real prices.
That is, all future cash flows are expected in terms of, say, Time 0’s prices.
With real cash flows, future cash flows are expressed in terms of constant
purchasing power.
1.3.2
EXAMPLE 2
Storm Co is evaluating Project X, which requires an initial investment of $50,000.
Expected net cash flows are $20,000 pa for four years at today’s prices. However
these are expected to rise by 5.5% pa because of inflation. The firm’s cost of capital
is 15%. Find the NPV by:
(a)
discounting money cash flows
(b)
discounting real cash flows.
Solution:
(a)
Discounting money cash flow at the money rate: The cash flows at today’s
prices are inflated by 5.5% for every year to take account of inflation and
convert them into money flows. They are then discounted using the money
cost of capital.
P. 97
Note: The question simply refers to the ‘firm’s cost of capital’. You can assume this
is the money rate – if you are given a real rate the examiner will always specify.
Time
0
1
2
3
Money cash flow
($)
(50,000)
21,100
22,261
23,485
Discount rate
@ 15%
1
0.870
0.756
0.658
(50,000)
18,357
16,829
15,453
4
24,776
0.572
14,172
NPV =
PV ($)
14,811
(b)
Calculate the real rate by removing the general inflation from the money cost of
capital:
(1 + r) = (1 + i) / (1 + h)
= (1 + 15%) / (1 + 5.5%)
P. 98
= 1.09
r = 9%
The real rate can now be applied to the real flows without any further adjustments.
Time
Real cash flow Discount rate
PV ($)
($)
@ 9%
0
(50,000)
1.000
(50,000)
1–4
20,000
3.240
64,800
NPV =
14,800
Note: Differences due to rounding.
1.3.3 In situations where you are given a number of specific inflation rates, the real method
outlined above cannot be used.
1.3.4 The following gives a useful summary of how to approach examination questions.
1.3.5 If a question contains both tax and inflation, it is advisable to use the money method.
P. 99
Multiple Choice Questions
I.
Inflation
1.
When appraising investment projects using discounted cash flow methods, two
approaches to dealing with inflation could be used. These are:
1.
2.
to exclude inflation from the estimated future cash flows and to apply a discount
rate based on the money cost of capital.
to include inflation in the estimated future cash flows and to apply a discount
based on the real cost of capital.
Which ONE of the following combinations (true/false) concerning the above
statements is correct?
A
B
C
D
2.
Statement 1
True
True
False
False
Statement 2
True
False
True
False
To deal with the effect of inflation when appraising investment projects, two possible
approaches can be used. These are:
1.
2.
To exclude inflation from the estimated future cash flows and to apply a discount
rate expressed in real terms.
To adjust the estimated future cash flows by the relevant rates of inflation and to
adjust the discount rate to reflect current market rates.
Which one of the following combinations is correct?
A
B
C
D
Statement 1
True
True
False
False
Statement 2
True
False
True
False
P. 100
3.
The one year rate of inflation is expected to be 3·0%. The one year money rate of
interest is 6·3%.
The one year real rate of interest is:
A
B
C
D
4.
3·30%
3·20%
9·30%
9·49%.
Dunlin plc is examining an investment opportunity that will lead to savings in staff
costs. The company uses the net present value method of investment appraisal based
on cash flows expressed in real terms. Staff costs are expected to rise at a rate of 5%
each year, whereas the general rate of inflation is expected to rise at a rate of 3% each
year. The company has a required rate of return of 10%, assuming no inflation.
What is the appropriate discount rate to use when evaluating the investment
opportunity?
5.
A
10%
B
C
D
13%
13·3%
15·5%.
Consider the following statements.
When using the net present value method of investment appraisal, the required rate of
return from investors is used as the appropriate discount factor. This rate of return
should be:
(1)
(2)
calculated on an after-tax basis
expressed in real terms if the cash flows are expressed in terms of the actual
number of dollars to be received.
Which one of the following combinations (true/false) concerning the above statements
is correct?
P. 101
Statement 1
True
True
False
False
A
B
C
D
6.
Statement 2
True
False
True
False
A project consists of a series of cash outflows in the first few years followed by a
series of positive cash inflows. The total cash inflows exceed the total cash outflows.
The project was originally evaluated assuming a zero rate of inflation.
If the project were re-evaluated on the assumption that the cash flows were subject to a
positive rate of inflation, what would be the effect on the payback period and the
internal rate of return?
Payback
Increase
Decrease
Decrease
Increase
A
B
C
D
7.
IRR
Increase
Decrease
Increase
Decrease
Spotty Ltd plans to purchase a machine costing $18,000 to save labour costs. Labour
savings would be $10,000 in the first year and labour rates in the second year will
increase by 10%. The estimated average annual rate of inflation is 9% and the
company’s real cost of capital is estimated at 11%. The machine has a two year life
with an estimated actual salvage value of $5,000 receivable at the end of year 2. All
cash flows occur at the year end.
What is the NPV (to the nearest $10) of the proposed investment?
A
$50
B
C
D
$270
$370
$1,430
P. 102
8.
A project has an initial outflow at year 0 when an asset is bought, then a series of
revenue inflows at the end of each year, and then finally sales proceeds from the sale
of the asset. Its NPV is $12,000 when general inflation is zero % per year.
If general inflation were to be rise to 7% per year, and all revenue inflows were subject
to this rate of inflation but the initial expenditure and resale value of the asset were not
subject to inflation, what would happen to the NPV?
9.
A
B
C
The NPV would remain the same
The NPV would rise
The NPV would fall
D
The NPV could rise or fall
Data of relevance to the evaluation of a particular project is given below.
Cost of capital in real terms 10% per annum
Expected inflation 5% per annum
Expected increase in the project's annual cash inflow 6% per annum
Expected increase in the project's annual cash outflow 4% per annum
Which one of the following sets of adjustments will lead to the correct NPV being
calculated?
A
B
C
D
Cash inflow
Unadjusted
5% pa increase
6% pa increase
6% pa increase
Cash outflow
Unadjusted
5% pa increase
4% pa increase
4% pa increase
P. 103
Discount %
10.0%
15.5%
15.0%
15.5%
2.
Taxation and Investment Appraisal
(Pilot, Jun 07, Dec 07, Jun 08, Dec 08, Jun 10, Dec 10, Jun 11, Dec 11, Jun 12, Dec 12,
Jun 13, Dec 13, Jun 14, Dec 14)
2.1
Tax payable
2.1.1 Taxation can have an important impact on project viability. If management are
implementing decisions that are shareholder wealth enhancing, they will focus on the
cash flows generated which are available for shareholders. Therefore, they will
evaluate the after-tax cash flows of a project.
2.1.2 Payments of tax, or reductions of tax payments, are cash flows and ought to be
considered in DCF analysis. Assumptions which may be stated in questions are as
follows.
2.2
(a)
Tax is payable in the year following the one in which the taxable profits are
made. Thus, if a project increases taxable profits by $10,000 in year 2, there
will be a tax payment, assuming tax at 30%, of $3,000 in year 3.
(b)
Net cash flows from a project should be considered as the taxable profits (not
just the taxable revenues) arising from the project.
Capital allowances (tax-allowable depreciation, or writing down allowances
(WDAs) or depreciation allowances)
2.2.1 Writing down allowance is used to reduce taxable profits, and the consequent
reduction in a tax payment should be treated as a cash saving from the acceptance
of a project.
2.2.2
EXAMPLE 3
ABC Ltd is considering a project which will require the purchase of a machine for
$1,000,000 at time zero. This machine will have a scrap value at the end of its
four-year life: this will be equal to its written-down value. Inland Revenue
Department (IRD) permits a 25% declining balance writing-down allowance on the
machine each year. Corporation tax, at a rate of 30% of taxable income, is payable.
ABC Ltd’s required rate of return is 12%. Operating cash flows, excluding
depreciation, and before taxation, are forecast to be:
P. 104
Time (year)
Cash flows before tax
1
2
3
4
$
$
$
$
400,000
400,000
220,000
240,000
Note: All cash flows occur at year ends.
In order to calculate the NPV, first calculate the annual WDA. Note that each year
the WDA is equal to 25% of the asset value at the start of the year.
Years
Annual WDA ($)
Written-down value ($)
0
0
1,000,000
1
2
3
4
1,000,000 × 25% = 250,000
750,000 × 25% = 187,500
562,500 × 25% = 140,625
421,875 × 25% = 105,469
750,000
562,500
421,875
316,406
The next step is to derive the project’s incremental taxable income and to calculate
the tax payments.
Time (year)
1
2
3
4
$
$
$
$
Net income before WDA and tax
400,000
400,000
220,000
240,000
Less: WDA
250,000
187,500
140,625
105,469
Taxable profit
150,000
212,500
79,375
134,531
Tax payable at 30%
45,000
63,750
23,813
40,359
Finally, the total cash flows and NPV are calculated.
Time (year)
0
1
2
3
4
$
$
$
$
$
(1,000,000)
400,000
400,000
220,000
240,000
Incremental cash flow
before tax
Sale of machine
Tax payable
316,406
0
(45,000)
(63,750)
(23,813)
(40,359)
(1,000,000)
355,000
336,250
196,187
516,047
Discount factor @12%
1.0000
0.8929
0.7972
0.7118
0.6355
Discounted cash flow
(1,000,000)
316,980
268,059
139,646
327,948
Net cash flows
NPV = $52,633
P. 105
The assumption that machine can be sold at the end of the fourth year, for an
amount equal to the written-down value, may be unrealistic. It may turn out that the
machine is sold for the larger sum of $440,000. If this is the case, a balancing
charge will need to be made, because by the end of the third year IRD have already
permitted write-offs against taxable profit such that the machine is shown as having
a written-down value of $421,875. A year later its market value is found to be
$440,000. The balancing charge is equal to the sale value at Time 4 minus the
written-down value at Time 3, viz:
$440,000 – $421,875 = $18,125
Taxable profits for year 4 are now:
$
Pre-tax cash flows
Plus balancing charge
240,000
18,125
258,125
This result in a tax payment of $258,125 × 0.3 = $77,438 rather than $40,359.
Of course, the analyst does not have to wait until the actual sale of the asset to make
these modifications to a proposed project’s projected cash flows. It may be possible
to estimate a realistic scrap value at the outset.
An alternative scenario, where the scrap value is less than the Year 4 written-down
value, will require a balancing allowance. If the disposal value is $300,000 then the
machine cost the firm $700,000 ($1,000,000 – $300,000) but the tax written-down
allowances amount to only $683,594 ($1,000,000 – $316,406). The firm will
effectively be overcharged by IRD. In this case a balancing adjustment, amount to
$16,406 ($700,000 – $683,594), is made to reduce the tax payable.
Pre-tax cash flows
Less: Annual writing-down allowance
Less: Balancing allowance
$
240,000
(105,469)
(16,406)
Taxable profits
118,125
Tax payable @ 30%
35,438
P. 106
Multiple Choice Questions
II.
Taxation
10.
A company has 31 December as its accounting year end. On 1 January 2014 a new
machine costing $2,000,000 is purchased. The company expects to sell the machine on
31 December 2015 for $350,000.
The rate of corporation tax for the company is 30%. Tax-allowable depreciation is
obtained at 25% on the reducing balance basis, and a balancing allowance is available
on disposal of the asset. The company makes sufficient profits to obtain relief for
capital allowances as soon as they arise.
If the company’s cost of capital is 15% per annum, what is the present value of the
tax-allowable depreciation at 1 January 2014 (to the nearest thousand dollars)?
A
B
C
D
11.
$391,000
$248,000
$263,000
$719,000
Jones Ltd plans to spend $90,000 on an item of capital equipment on 1 January 2012.
The expenditure is eligible for 25% tax-allowable depreciation, and Jones pays
corporation tax at 30%. Tax is paid at the end of the accounting period concerned. The
equipment will produce savings of $30,000 per annum for its expected useful life
deemed to be receivable every 31 December. The equipment will be sold for $25,000
on 31 December 2015. Jones has a 31 December year end and has a 10% post-tax cost
of capital.
What is the present value at 1 January 2012 of the tax savings that result from the
capital allowances?
A
B
C
D
$13,170
$15,826
$16,018
$19,827
P. 107
12.
A company receives a perpetuity of $20,000 per annum in arrears, and pays 30%
corporation tax 12 months after the end of the year to which the cash flows relate.
At a cost of capital of 10%, what is the after tax present value?
A
B
C
D
13.
$140,000
$145,460
$144,000
$127,274
A project has an annual net cash inflow (in current terms) of $3 million, occurring at
the end of each year of the project's two year life. An investment of $3.5 million is
made at the outset. All cash inflows are subject to corporation tax of 30%, payable
when the cash is received. There is no tax allowable depreciation on the initial
investment. An average inflation rate of 5% per annum is expected to affect the
inflows of the project.
The cost of capital in money terms is 15.5%
What is the expected net present value of the project (to the nearest $100)?
A
B
C
D
14.
$92,600
$145,970
$286,600
$367,400
An asset costing $40,000 is expected to last for three years, after which is can be sold
for $16,000. The corporation tax rate is 30%, tax allowable depreciation at 25% is
available, and the cost of capital is 10%. Tax is payable at the end of each financial
year.
Capital expenditure occurs on the last day of a financial year, and the tax allowable
depreciation is claimed as early as possible.
What is the cash flow in respect of tax allowable depreciation that will be used at time
2 of the net present value calculation?
P. 108
15.
A
$1,688
B
C
D
$2,250
$5,624
$7,500
The details of an investment project are as follows.
Life of the project
Cost of asset bought at the start of the project
Annual cash inflow
Cost of capital, after tax
10 years
$100,000
$20,000
8% each year
Corporation tax is 30% and is paid half in the year and half in the following year, in
equal quarterly instalments. The instalments are in the 7th and 10th months of the year
in which the profit was earned and in the 1st and 4th months of the following year.
Tax allowable depreciation of 25% reducing balance will be claimed each year.
(Assume the asset is bought on the first day of the tax year and that the company's
other projects generate healthy profits.)
(Round all cash flows to the nearest $ and discount end of year cash flows.)
What is the present value of the cash flows that occur in the second year of the
project?
A
B
C
D
17,622
18,426
20,193
22,764
P. 109
Question 1 – NPV with inflation and tax allowable depreciation
Uftin Co is a large company which is listed on a major stock market. The company has been
evaluating an investment proposal to manufacture Product K3J. The initial investment of
$1,800,000 will be payable at the start of the first year of operation. The following draft
evaluation has been prepared by a junior employee.
Year
Sales (units/year)
Selling price ($/unit)
Variable costs ($/unit)
1
95,000
25
11
2
100,000
25
12
3
150,000
26
12
4
150,000
27
13
(Note: The above selling prices and variable costs per unit have not been inflated.)
Year
Sales revenue
Variable costs
Fixed costs
Interest payments
$000
2,475
(1,097)
(155)
(150)
$000
2,605
(1,260)
(155)
(150)
$000
4,064
(1,890)
(155)
(150)
$000
4,220
(2,048)
(155)
(150)
Cash flow before tax
1,073
1,040
1,869
1,867
Tax allowable depreciation
(450)
(450)
(450)
(450)
623
590
(137)
1,419
(130)
1,417
(312)
623
0.893
453
0.797
1,289
0.712
1,105
0.636
556
361
918
703
Taxable profit
Taxation
Net cash flow
Discount at 12%
Present values
Present value of cash inflows
Cost of machine
NPV
2,538
(1,800)
738
The junior employee also provided the following information:
1.
Relevant fixed costs are forecast to be $150,000 per year.
2.
Sales and production volumes are the same and no finished goods inventory is held.
3.
The corporation tax rate is 22% per year and tax liabilities are payable one year in
arrears.
4.
Uftin Co can claim tax allowable depreciation of 25% per year on a reducing balance
basis on the initial investment.
P. 110
5.
A balancing charge or allowance can be claimed at the end of the fourth year.
6.
It is expected that selling price inflation will be 4·2% per year, variable cost inflation
will be 5% per year and fixed cost inflation will be 3% per year.
The investment has no scrap value.
The investment will be partly financed by a $1,500,000 loan at 10% per year.
Uftin Co has a weighted average cost of capital of 12% per year.
7.
8.
9.
Required:
(a)
Prepare a revised draft evaluation of the investment proposal and comment on its
financial acceptability.
(11 marks)
(b)
Explain any TWO revisions you have made to the draft evaluation in part (a) above.
(4 marks)
(15 marks)
(ACCA F9 Financial Management December 2014 Q4)
Question 2 – NPV with tax allowance
Hendil plc plans to invest £1 million in a new product range and has forecast the following
financial information:
Year
1
2
3
4
70,000
90,000
100,000
75,000
Average selling price (£/unit)
40
45
51
51
Average variable costs (£/unit)
30
28
27
27
500,000
500,000
500,000
500,000
Sales volume (units)
Incremental cash fixed costs (£/year)
The above cost forecasts have been prepared on the basis of current prices and no account
has been taken of inflation of 4% per year on variable costs and 3% per year on fixed costs.
Working capital investment accounts for £200,000 of the proposed £1 million investment
and machinery for £800,000.
Hendil uses a four-year evaluation period for capital investment purposes, but expects the
new product range to continue to sell for several years after the end of this period. Capital
investments are expected to pay back within two years on an undiscounted basis, and within
three years on a discounted basis.
The company pays tax on profits in the year in which liabilities arise at an annual rate of
30% and claims capital allowances on machinery on a 25% reducing balance basis.
P. 111
Balancing allowances or charges are claimed only on the disposal of assets.
Required:
(a)
(b)
(c)
Using Hendil plc’s current average cost of capital of 11%, calculate the net present
value of the proposed investment.
(15 marks)
Calculate, to the nearest month, the payback period and the discounted payback period
of the proposed investment.
(4 marks)
Discuss the acceptability of the proposed investment and explain ways in which your
net present value calculation could be improved.
(6 marks)
(Total 25 marks)
(Amended ACCA Paper 2.4 Financial Management and Control December 2006 Q1)
3.
3.1
3.2
3.3
Incorporating Working Capital
(Jun 08, Dec 08, Jun 11, Dec 11, Jun13, Dec 13)
Investment in a new project often requires an additional investment in working
capital, i.e. the difference between short-term assets and liabilities.
The treatment of working capital is as follows:
(a)
(b)
Initial investment is a cost at the start of the project.
If the investment is increased during the project, the increase is a relevant
(c)
cash outflow.
At the end of the project all the working capital is released and treated as
cash inflow.
EXAMPLE 4
A company expects sales for a new project to be $225,000 in the first year growing
at 5% pa. The project is expected to last for 4 years. 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 flows for incorporation into the NPV calculation.
Solution:
Calculate the absolute amounts of working capital needed over the project:
Year
0
1
2
3
4
$
$
$
$
$
225,000
236,250
248,063
260,466
23,625
24,806
26,047
Sales
Working capital (10% sales)
22,500
P. 112
Work out the incremental investment required each year (remember that the full
investment is released at the end of the project):
Year
0
1
2
3
4
$
$
$
$
$
23,625 –
24,806 –
26,047 –
22,500
23,625
24,806
(1,125)
(1,181)
(1,241)
Working
Working capital investment
(22,500)
26,047
Multiple Choice Questions
III. Incorporating working Capital
16.
A project has the following projected cash inflows.
Year 1 100,000
Year 2 125,000
Year 3 105,000
Working capital is required to be in place at the start of each year equal to 10% of the
cash inflow for that year. The cost of capital is 10%.
What is the present value of the working capital?
A
B
C
D
17.
$ Nil
$(30,036)
$(2,735)
$33,000
AW Co needs to have $100,000 working capital in place immediately for the start of a
2 year project. The amount will stay constant in real terms. Inflation is running at 10%
per annum, and AW Co’s money cost of capital is 12%.
What is the present value of the cash flows relating to working capital?
A
B
C
D
$(21,260)
$(20,300)
$(108,730)
$(4,090)
P. 113
18.
A new project is expected to generate sales of 55,000 units per year. The selling price
is expected to be $3.50 per unit in the first year, growing at 6% pa. The project is
expected to last for three years. Working capital equal to 12% of annual sales is
required and needs to be in place at the start of each year.
What is the cash flow in respect of working capital that will be used at time 2 of the
net present value calculation?
A
B
$(25,955)
$(24,486)
C
D
$(1,386)
$(1,469)
4.
4.1
General layout of cash flow preparation
The general layout can be shown as follows:
Year
0
1
2
3
4
$000
$000
$000
$000
$000
Sales
X
X
X
Costs
(X)
(X)
(X)
X
X
X
(X)
(X)
(X)
X
X
X
Operating cash flows
Taxation
Tax benefit of CAs
Capital expenditure and scrap value
(X)
Working capital changes
(X)
(X)
(X)
(X)
X
Net cash flows
(X)
X
X
X
X
Discount factor
X
X
X
X
X
(X)
X
X
X
X
Present value
X
P. 114
Question 3 – NPV with inflation, capital allowances and working capital
SC Co is evaluating the purchase of a new machine to produce product P, which has a short
product life-cycle due to rapidly changing technology. The machine is expected to cost $1
million. Production and sales of product P are forecast to be as follows:
Year
Production and sales (units/year)
1
35,000
2
53,000
3
75,000
4
36,000
The selling price of product P (in current price terms) will be $20 per unit, while the variable
cost of the product (in current price terms) will be $12 per unit. Selling price inflation is
expected to be 4% per year and variable cost inflation is expected to be 5% per year. No
increase in existing fixed costs is expected since SC Co has spare capacity in both space and
labour terms.
Producing and selling product P will call for increased investment in working capital.
Analysis of historical levels of working capital within SC Co indicates that at the start of
each year, investment in working capital for product P will need to be 7% of sales revenue
for that year.
SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to
tax is reduced by capital allowances on machinery (tax-allowable depreciation), which SC
Co can claim on a straight-line basis over the four-year life of the proposed investment. The
new machine is expected to have no scrap value at the end of the four-year period.
SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment
appraisal purposes.
Required:
(a) Calculate the net present value of the proposed investment in product P.
(12 marks)
(b) Calculate the internal rate of return of the proposed investment in product P.
(c)
(d)
(3 marks)
Advise on the acceptability of the proposed investment in product P and discuss the
limitations of the evaluations you have carried out.
(5 marks)
Discuss how the net present value method of investment appraisal contributes towards
the objective of maximising the wealth of shareholders.
(5 marks)
(Total 25 marks)
(ACCA F9 Financial Management June 2008 Q4)
P. 115
Additional Examination Style Questions
Question 4 – NPV and IRR
Charm plc, a software company, has developed a new game, ‘Fingo’, which it plans to launch
in the near future. Sales of the new game are expected to be very strong, following a
favourable review by a popular PC magazine. Charm plc has been informed that the review
will give the game a ‘Best Buy’ recommendation. Sales volumes, production volumes and
selling prices for ‘Fingo’ over its four-year life are expected to be as follows.
Year
Sales and production (units)
Selling price (£ per game)
1
150,000
2
70,000
3
60,000
4
60,000
£25
£24
£23
£22
Financial information on ‘Fingo’ for the first year of production is as follows:
Direct material cost
Other variable production cost
Fixed costs
£5.40 per game
£6.00 per game
£4.00 per game
Advertising costs to stimulate demand are expected to be £650,000 in the first year of
production and £100,000 in the second year of production. No advertising costs are expected
in the third and fourth years of production. Fixed costs represent incremental cash fixed
production overheads. ‘Fingo’ will be produced on a new production machine costing
£800,000. Although this production machine is expected to have a useful life of up to ten
years, government legislation allows Charm plc to claim the capital cost of the machine
against the manufacture of a single product. Capital allowances will therefore be claimed on a
straight-line basis over four years.
Charm plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year
in which they arise. Charm plc uses an after-tax discount rate of 10% when appraising new
capital investments. Ignore inflation.
Required:
(a)
(b)
Calculate the net present value of the proposed investment and comment on your
findings.
(11 marks)
Calculate the internal rate of return of the proposed investment and comment on your
findings.
(5 marks)
P. 116
(c)
Discuss the reasons why the net present value investment appraisal method is preferred
to other investment appraisal methods such as payback, return on capital employed and
internal rate of return.
(9 marks)
(Total 25 marks)
(ACCA Paper 2.4 Financial Management and Control June 2006 Q5)
Question 5 – NPV with inflation
Trecor Co plans to buy a new machine to meet expected demand for a new product, Product T.
This machine will cost $250,000 and last for four years, at the end of which time it will be
sold for $5,000. Trecor Co expects demand for Product T to be as follows:
Year
Demand (units)
1
35,000
2
40,000
3
50,000
4
25,000
The selling price for Product T is expected to be $12.00 per unit and the variable cost of
production is expected to be $7.80 per unit. Incremental annual fixed production overheads of
$25,000 per year will be incurred. Selling price and costs are all in current price terms.
Selling price and costs are expected to increase as follows:
Increase
Selling price of Product T:
3% per year
Variable cost of production:
Fixed production overheads:
4% per year
6% per year
Other information:
Trecor Co has a real cost of capital of 5.7% and pays tax at an annual rate of 30% one year in
arrears. It can claim capital allowances on a 25% reducing balance basis. General inflation is
expected to be 5% per year.
Trecor Co has a target return on capital employed of 20%. Depreciation is charged on a
straight-line basis over the life of an asset.
Required:
(a)
(b)
Calculate the net present value of buying the new machine and comment on your
findings (work to the nearest $1,000).
(13 marks)
Calculate the before-tax return on capital employed (accounting rate of return) based on
the average investment and comment on your findings.
(5 marks)
P. 117
(c)
Discuss the strengths and weaknesses of internal rate of return in appraising capital
investments.
(7 marks)
(ACCA F9 Financial Management Pilot Paper Q4)
Question 6 – NPV with tax allowance and IRR
Duo Co needs to increase production capacity to meet increasing demand for an existing
product, ‘Quago’, which is used in food processing. A new machine, with a useful life of four
years and a maximum output of 600,000 kg of Quago per year, could be bought for $800,000,
payable immediately. The scrap value of the machine after four years would be $30,000.
Forecast demand and production of Quago over the next four years is as follows:
Year
Demand (units)
1
1.4 million
2
1.5 million
3
1.6 million
4
1.7 million
Existing production capacity for Quago is limited to one million kilograms per year and the
new machine would only be used for demand additional to this.
The current selling price of Quago is $8.00 per kilogram and the variable cost of materials is
$5.00 per kilogram. Other variable costs of production are $1.90 per kilogram. Fixed costs of
production associated with the new machine would be $240,000 in the first year of production,
increasing by $20,000 per year in each subsequent year of operation.
Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances
(tax-allowable depreciation) on a 25% reducing balance basis. A balancing allowance is
claimed in the final year of operation.
Duo Co uses its after-tax weighted average cost of capital when appraising investment
projects. It has a cost of equity of 11% and a before-tax cost of debt of 8·6%. The long-term
finance of the company, on a market-value basis, consists of 80% equity and 20% debt.
Required:
(a)
(b)
(c)
Calculate the net present value of buying the new machine and advise on the
acceptability of the proposed purchase (work to the nearest $1,000).
(13 marks)
Calculate the internal rate of return of buying the new machine and advise on the
acceptability of the proposed purchase (work to the nearest $1,000).
(4 marks)
Explain the difference between risk and uncertainty in the context of investment
P. 118
appraisal, and describe how sensitivity analysis and probability analysis can be used to
incorporate risk into the investment appraisal process.
(8 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2007 Q2)
Question 7 – NPV with inflation and Discounted Payback
PV Co is evaluating an investment proposal to manufacture Product W33, which has
performed well in test marketing trials conducted recently by the company’s research and
development division. The following information relating to this investment proposal has now
been prepared.
Initial investment
Selling price (current price terms)
Expected selling price inflation
$2 million
$20 per unit
3% per year
Variable operating costs (current price terms)
Fixed operating costs (current price terms)
Expected operating cost inflation
$8 per unit
$170,000 per year
4% per year
The research and development division has prepared the following demand forecast as a result
of its test marketing trials. The forecast reflects expected technological change and its effect
on the anticipated life-cycle of Product W33.
Year
Demand (units)
1
60,000
2
70,000
3
120,000
4
45,000
It is expected that all units of Product W33 produced will be sold, in line with the company’s
policy of keeping no inventory of finished goods. No terminal value or machinery scrap value
is expected at the end of four years, when production of Product W33 is planned to end. For
investment appraisal purposes, PV Co uses a nominal (money) discount rate of 10% per year
and a target return on capital employed of 30% per year. Ignore taxation.
Required:
(a)
(b)
Identify and explain the key stages in the capital investment decision-making process,
and the role of investment appraisal in this process.
(7 marks)
Calculate the following values for the investment proposal:
(i) net present value;
(ii) internal rate of return;
P. 119
(iii) return on capital employed (accounting rate of return) based on average
investment; and
(iv) discounted payback period.
(c)
(13 marks)
Discuss your findings in each section of (b) above and advise whether the investment
proposal is financially acceptable.
(5 marks)
(Total 25 marks)
(ACCA F9 Financial Management June 2009 Q2)
P. 120