Investment Appraisal

The main stages in the investment appraisal process are:

There are various methods and tools for stage 3 i.e. financial analysis

1) Return on capital employed (ROCE)

A traditional approach to evaluating investments is to evaluate the profit from the
investment as a % of the amount invested. ROCE is also called accounting rate of return
(ARR) and return on investment (ROI).

ROCE = Average annual profit from investment X 100

Initial Investment

or Average annual profit from investment X 100

Average Investment
where average investment = (initial outlay + scrap value) / 2
Note: profit is after depreciation but before interest and tax

Q.1 B & R are considering expanding their retaurant business through purchase of the
Parkway Diner, which will cost Rs. 350,000 to take over the business and a further
Rs. 150,000 to refurbish the premises with new equipment. Cash flow projections from
the project show the following profit over the next six years
Year Net Profit
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
The equipment will be depreciated to a zero resale value over the same period and, after
the sixth year, B & R confidently expect that they could sell the business for Rs. 150,000
Required
Calculate the ROCE of this investment (using the average investment method)

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 Decision rule
Accept all projects with an ROCE above the company's target.
Advantages of ROCE
(a) Consistent with methods used to evaluate the company as a whole
(b) Relative score (%) is easy to understand
(c) Considers the whole life of the project

Disadvantages of ROCE
(a) Ignores the timing of the cash flows
(b) Worsens if a small amount of extra cash is earned in an extra year of the project
(c) Profits can be affected by costs that are not relevant costs

2) Payback period
This is a measure of how many years it takes for the cash flows affected by the decision
to invest to repay the cost of the original investment. A long payback period is considered
risky because it relies on cash flows that are in the distant future.

Q.2 Calculate payback period using the data of question 1.

Decision rule
Accept all projects with a payback period within the company's target payback period.

Advantages of payback
(a) A simple way of screening out projects that look too risky
(b) Useful when a company has cash flow problems

Disadvantages of payback
(a) Ignores the timing of the cash flows within the payback period
(b) Ignores the cash flows outside the payback period

Q.3 ABC Company is considering investment in one of the following two projects
Project A Project B
Rs'000' Rs'000'
Initial investment 1,500 1,800
Cash inflows Year 1 400 700
Year 2 450 750
Year 3 500 540
Year 4 550 400
Year 5 430

Scrap value of both project is 20% of initial investment

Required:
a) Calculate accounting rate of return of both projects
b) Calculate payback period of both projects
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 Neither ROCE nor payback are adequate methods of appraising capital investments by
themselves; the main problem with both methods is that they ignore the time value of
money, this area is addressed in the next chapter. Both methods are useful complements
to the more sophisticated methods that are looked at in the next chapter.

Time value of money

Many projects involve investing money now and receiving returns on the investment in the
future; so the timing of a project’s cash flows need to be analysed to see if they offer a better
return than the return an investor could get if they invested their money in other ways.

The process of adjusting a project’s cash flows to reflect the return that investors could get
elsewhere is called discounting.

3) Net present value (NPV)

If the discounted value of the future cash flows are higher than the cost of setting up a
project today, then the project has a + Net Present Value and should be accepted.

If a project involved the outlay of Rs 1,000 today and provided a definite return of Rs 560
per year for 2 years would you accept the project? (assume that you could get a return
of 5% on investments of similar risk).
PV of 560 receiving after 1 year = 560 x 0.9524 = 533(1/1.05)
PV of 560 receiving after 2 years = 560 x 0.9070 = 508
(1/1.05) x (1/1.05)
PV of 560 per annum for 2 years = 533 + 508 = 1041
Answer: Yes it should be accepted because its NPV is Rs 41 positive

Relevant costs
Only the cash flows affected by the decision to invest should be taken into account when
appraising investments, these are called relevant costs.

Q4 The Management Services Division of a company has been asked to evaluate the following
proposals for the maintenance of a new boiler with a life of seven years.
PROPOSAL 1
The boiler supplier will make a charge of Rs 13,000 per year on a seven-year contract.
PROPOSAL 2
The company will carry out its own maintenance estimated at Rs 10,000 per annum now,
rising at 5% per annum with a major overhaul at the end of year 4 costing an additional
Rs 25,000.
The discount rate is 10% and all payments are assumed to be made at year ends.
Required:
Calculate the net present value of both porposal and recommend, with reasons, which
proposal should be adopted.

Q5 Taxi Ltd is a long established company providing high quality transport for customers. It
currently owns and runs 350 cars and has a turnover of Rs 10 million per annum.
The current system for allocating jobs to drivers is very inefficient. Taxi Ltd is considering
the implementation of a new computerised tracking system called ‘Kwictrac’. This will make

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 the allocation of jobs far more efficient. The project is being appraised over five years.
The costs and benefits of the new system are set out below.
(i) The central tracking system costs Rs 2,100,000 to implement. This amount will be
payable in three equal instalments: one immediately, the second in one year’s time,
and the third in two years’ time.
(ii) Depreciation on the new system will be provided at Rs 420,000 per annum.
(iii) Staff will need to be trained how to use the new system. This will cost Taxi Ltd
Rs 425,000 in the first year.
(iv) If Kwictrac is implemented, revenues will rise to an estimated Rs 11 million this year,
thereafter increasing by 5% per annum (i.e. compounded). Even if Kwictrac is not
implemented, revenues will increase by an estimated Rs 200,000 per annum, from their
current level of Rs 10 million per annum.
(v) Despite increased revenues, Kwictrac will still make overall savings in terms of
vehicle running costs. These cost savings are estimated at 1% of the post Kwictrac
revenues each year.
(vi) Six new staff operatives will be recruited to manage the Kwictrac system. Their wages
will cost the company Rs 120,000 per annum in the first year, Rs 200,000 in the second
year, thereafter increasing by 5% per annum (i.e. compounded).
(vii) Taxi Ltd will have to take out a maintenance contract for the Kwictrac system. This
will cost Rs 75,000 per annum.
(viii) Interest on money borrowed to finance the project will cost Rs 150,000 per annum.
(ix) Taxi Ltd’s cost of capital is 10% per annum.
Required:
(a) Calculate the net present value of the new Kwictrac project to the nearest Rs 000. Use
the discount factors provided at the end of the question. (10 marks)
(b) Calculate the simple payback period for the project and interpret the result. (3 marks)
(c) Calculate the discounted payback period for the project and interpret the result. (3 marks)
(Ans NPV 2.762 million)

Q6 You are an assistant accountant in the pension department of a large life assurance and
pensions company. You have been co-opted on to a systems feasibility study team which is
investigating an upgrade in your department’s current computer systems. In particular, the
project team is investigating the adoption of a new method of capturing on-line, customer
employee data for certain group pension policy products.
The economic aspects of the study show that the use of on-line as opposed to manual data
entry could provide an average time saving of 45 minutes for each new group pension policy
file set up on the system. The estimated total cost per hour of the administrative staff who
currently enter policy data is Rs 30 per hour and about 3,000 policies of the type under review
are sold each year. The sales volume of a group pension business is expected to be 3,000
policies next year rising to 3,500 the following year, 4,000 the next and settling at 4,500
policies thereafter.
The new system can be developed and implemented at a cost of Rs 350,000. The new system
will replace an existing system which was only implemented two years ago at a cost of
Rs 200,000. Both systems could operate for a further five years at which time the method of
administering pension products is expected to change. Neither system would be required
after this time.

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 The written-down value of the current system stands at Rs 100,000 and the resale value of the
hardware component is currently Rs 75,000. This system would be expected to have a resale
value of no more than Rs 10,000 five years from now. The resale value of the new system
would be about Rs 65,000 five years from now.
Finally the new system would incur maintenance changes of Rs 35,000 per annum as opposed
to Rs 20,000 per annum for the current system.
You have been asked to contribute to the study by providing a financial analysis of the
proposed investment.

Required:
Using the net present value method prepare a discounted cash flow analysis of the proposed
new systems. The cost of finance of the pensions company is estimated at 11%. Ignore the
effects of taxation and inflation. (20 marks)
(Ans NPV Rs 19,522)

Q7 Board of Directors of Target Industries is planning to invest Rs.1,000,000 on new project

May in order to expand its business. Three trading projects ‘A’, ‘B’ and ‘C’ are being
2014 considered, each involving the immediate purchase of equipment costing Rs.1,000,000.
Only one of the three projects can be undertaken. The equipment for each project will
have a useful life equal to that of the project, with no scrap value and a reducing
balance method is used for depreciation.
Projected Net Cash Flow Rs. ‘000’
Project Year
0 1 2 3 4 5 6 7
A (1,000) 286 314 297 320 394 457 514 –
B (1,000) 114 286 600 743 457 –––
C (1,000) 571 429 686 114 ––––

Required:
(i) Calculate the payback period for each project. 04
(ii) Calculate accounting rate of return (ARR) for each project. 07
(iii) Rank the projects according to payback period and ARR 03
(b) Target Industries is also considering to invest in a manufacturing project that would have
a five-year life span. In each year of operation, 80,000 units would be produced and
sold. The contribution per unit, based on current price, is Rs.40.
The company’s cost of capital / nominal rate is 15%.
Required:
Calculate net present value (NPV) of the manufacturing project. 08
(Ans NPV Rs 13.03m)

Q8 M/s. Mexican Ltd., is a manufacturer of sports goods and is proposing to manufacture

Aug new product line. The product line is expected to have 4 years life. You have recently
2014 been appointed as a Management Accountant for this project and have been delegated
the responsibility of preparing the financial evaluation of the proposed investment.
You have been provided with the following information related to the new product line:

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 Rupees Rupees
Sales 9,000 units @ Rs. 32 288,000
Cost of Goods sold:
Labour 40,000 hours @ Rs. 3.50 per hour 140,000
Materials and other variable costs 65,000
Depreciation 45,000
Less: Closing stock (25,000) 225,000
Net profit 63,000

Other data relating to new product line:

• Annual sales volume at 9,000 units is expected to be constant over the period of
four years.
• Production which was estimated at 10,000 units in the first year would be 9,000
units each in year two and three, and 8,000 units in year four.
• Debtors at the end of each year would be 20% of sales during the year and
creditors would be 10% of materials and other variable costs. (The policy of the
company is to collect its 80% of debtors in the current year and remaining in the
next year following the sale and creditors are paid 90% in the year of purchase and
10% in the next year).
• Special machinery would be purchased for manufacturing of the new product and
its depreciation will be calculated on the straight line basis. Assume that the
machinery would last for four years and have no terminal scrap value.
• Cost of capital of M/s. Mexican Ltd., is 20% per annum.
Required:
Calculate the net present value (NPV) of the product line and state whether the
manufacturing of the new product is worthwhile. Ignore taxation. 15
(Ans NPV Rs 58397)

Q.9 Wotton Inc is a small company specialising in the manufacture of high quality machine
components using the latest techniques and materials. Sue, the owner, is a keen cyclist
and has been considering the possibility of making very strong lightweight sets of bicycle
gears out of titanium. Research and development cost of Rs 20,000 have been incurred,
which indicate that the cycle parts can be manufactured to the required quality and weight
and that a market would exist for the sets of gears.
As an outside consultant you have been asked to appraise the venture, and are supplied
with the following information.

1 Sales are anticipated to be 500 sets per annum for the next five years. Ignoring
inflation, the sets should sell for Rs 600 each to enthusiasts.
2 Advertising costs would be Rs 5,000 in the first year and Rs 1,000 per annum
thereafter.
3 Each set of gears requires 0.5 kg of titanium at Rs 600/kg, 10 hours of skilled
labour, 4 hours of unskilled labour and 2 hours in the automated finishing room.
4 Skilled workers are paid Rs 10 per hour with time and a half for overtime. They
are guaranteed 2,000 hours per annum, however, at present the 15 workers

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 are only 90% utilised. No further skilled workers will be recruited. Unskilled
workers are paid Rs 7 per hour and are only hired when required.
5 The finishing room incurs variable cost of Rs 10 per hour when in use. At present
the production of Wotton Inc's existing machine components fully utilizes the
room, generating contribution of Rs 5 per hour. For the first two years Sue will
have to cut back on this production in order to have sufficient capacity to finish
the new product. However, in two year's time the finishing room will be expanded
at a cost of Rs 2,000 in order that production of the old product can be brought
back up to its current levels.
6 The cycle parts venture would also require the use of an existing machine (net
book value Rs 40,000) which would otherwise be sold for Rs 60,000. The asset is
expected to be worthless in five years' time.
7 Wotton Inc. currently absorbs fixed overheads at Rs 6 per direct labour hour.
8 In the past Sue has used a required return of 20% to assess projects.

Required:
Write a report to Miss Sue Wotton advising her on whether she should go ahead with the
bicycle parts project. Your report should include the following:
a) An evaluation of the project using return on capital employed (ROCE) based on the
initial capital employed. (6 Marks)
b) An evaluation of the project based on its NPV (8 Marks)
c) An explanation of any figures treated differently in the two calculations above.

4) Internal rate of return (IRR)

Internal rate of return is a discounted cash flow technique of a project that calculates the
% return given by a project.
Formula IRR = a + NPVa X (b - a)
NPVa - NPVb

Where a is the first discount rate giving NPVa (ie 5%)

b is the second discount rate giving NPVb (ie 10%)

Q 10 CAT Ltd is evaluating a capital expenditure project. The details are as follows:
1 The project has an immediate cost of Rs 110,000 and after its five-year life, has a nil
residual value. There are no capital allowances available.
2 Sales are expected to be Rs 80,000 for years 1 and 2, Rs 60,000 per annum for years 3,
4 and 5.
3 Cost of sales is 50% of sales,
4 Tax at 10% is payable in the year the profit is earned.
5 The company’s cost of capital is 10%.
Required:
Calculate the project’s IRR, (assuming that all cash flows arise annually in
arrears). (8 marks)

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Q 11 Rajanpur Fabrication Ltd produce specialised screens for the quarrying industry. They are
planning to introduce a new product, the ‘mini screen’ which will require additional capital
investment of Rs 250,000. The Company has a strategic policy that all new projects should
achieve an IRR – internal rate of returns – of at least 30%.
The accounting technician and the production manager together with the sales staff have
produced the following forecasts for a five-year period (the project life). The machinery will
be scrapped at the end of the period.
Sales and production volume – units
Year 1 1,000
2 2,000
3 3,000
4 1,000
5 500
Projected selling price Rs 600/unit.
Variable costs per unit:
Materials Rs 300
Labour Rs 100
Variable overhead Rs 25
Fixed costs per period Rs 220,000 (allocated to the product group) includes depreciation on a
straight line basis.

Required:
(a) (i) Explain the term payback period. (2 marks)
(ii) Calculate the payback period for the project. (6 marks)
(iii) Outline two advantages and two disadvantages of using payback as a method of
appraisal. (2 marks)
(b) Calculate the IRR for the project and state with reasons whether or not Ravenscar
should invest in the new product and machinery. (10 marks) (Answer 30.32%)

Q 12 Rainbow Ltd, a medium-sized company specialising in the manufacture and distribution of

equipment for babies and small children, is evaluating a new capital expenditure project.
Together with another company outside the group, it has invented a remote controlled
pushchair, one of the first of its kind on the market. It has been unable to obtain a patent for
the invention, but is sure that it will monopolise the market for the first three years. After
this, it expects to be faced with stiff competition.
The details are set out below.

1 The project has an immediate cost of Rs 2,100,000.

2 Sales are expected to be Rs 1,550,000 per annum for years 1 to 3, falling to Rs 650,000
per annum for the two years after that. No further sales of the product are expected
after the end of this five-year period.
3 Cost of sales is 40% of sales.
4 Distribution costs represent 10% of sales.
5 20% of net profits are payable to their co-inventor one year after the profit is earned.
6 The company’s cost of capital is 5%.

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 Required:
(a) (i) Calculate the net present value of the project at the company’s required rate of
return. Assume that all cash flows arise annually in arrears. Conclude whether
the project is financially viable. (8 marks)
(ii) Calculate the project’s internal rate of return (IRR) to the nearest percent, using
discount factors of 5% and 10%. (4 marks)
(b) Calculate the project’s simple payback period. (4 marks) (Answer NPV 32,000)

Q 13 Puzzler Ltd is investing in new machinery to upgrade its production facilities. Two mutually
exclusive machines have been identified and the managing director must now make a final
decision on which of the two to accept. He has asked for a report setting out key financial
data in respect of both machines to assist in the final decision.
The financial controller, to whom you report, has provided you with the following
information in respect of both machines and has asked your input to the report.

Machine A Machine B
Rs Rs
Immediate cost 52,000 52,000
Estimated net annual cash inflows
Year 1 25,000 6,000
Year 2 20,000 16,000
Year 3 15,000 20,000
Year 4 3,000 32,000
Estimated life of the investment 4 years 4 years
Anticipated scrap value at the end
of the four years 12,000 16,000
The assets will be depreciated using straight line depreciation.

Required:
(a) (i) Explain the term accounting rate of return, (ARR) sometimes referred to as
return on capital employed (ROCE). (2 marks)
(ii) Calculate the ARR of both machines (using average annual profit as a
percentage of average investment). (6 marks)
(b) (i) Calculate the internal rate of return (IRR) of both machines. (8 marks)
(ii) Identify TWO main differences between ARR and IRR. (4 marks)
(Answer ARR 17.9% & 27.9% - IRR 18.5% & 19.2%)

Q.14 Royal Engineering is considering the introduction of a new product which will have a life
(Nov of five years. Two alternative methods of promoting the product are as under:
2008) Alternative - 1:
This option will involve employing a large number of agents. An immediate
expenditure of Rs.2,500,000 will be required to advertise the product. This will
produce net annual cash inflows of Rs.1,500,000 at the end of each year. However,
the agents will have to be paid Rs.250,000 each year. On termination of the contract,
the agents will have to be paid a lump sum of Rs.500,000 at the end of the fifth year.

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 Alternative - 2:
Under this alternative, the company will not employ agents but will sell directly to
the consumers. The initial expenditure of advertising will be Rs.1,250,000. This will
bring in cash inflows at the end of each year of Rs.750,000. However, this
alternative will involve out-of-pocket cost for sales administration to the extent of
Rs.250,000. The company also proposes to allocate fixed cost worth Rs.100,000
per year to this product, if this alternative is pursued.
(You may assume that the firm's cost of capital is 20% per annum).

Required:
(a) Advise the management as to the best method of promotion to be adopted.
(b) Calculate the internal rate of return (IRR) for Alternative-2.

Q.15 Dubai Ferry Company provides ferry service between Karachi and Dubai. One of its
(Nov small ferry boats is in poor condition. This ferry can be renovated at an immediate cost
2007) of Rs. 2,000,000. Further repairs and an overhaul of the motor will be needed five years
from now at cost of Rs. 800,000. In all, the ferry will be useable for 10 years if this
work is done. At the end of 10 years, the ferry will have to be scrapped at a salvage value
of Rs. 600,000. The scrap value of ferry right now is Rs. 700,000. It will cost Rs. 3 million
each year to operate the ferry, and revenue will total Rs. 4 million annually.

As an alternate, DFC can purchase a new ferry boat at a cost of Rs. 3.6 million. The new
ferry will have a life of 10 years, but it will require some repairs at the end of five years. It
is estimated that these repairs will amount to Rs. 300,000. At the end of 10 years, it is
estimated that ferry will have a scrap value of Rs. 600,000. It will cost Rs. 2.1 million each
year to operate the ferry, and revenue will total Rs. 4 million annually.

DFC requires a return of at least 14% before taxes on all investment projects.

Required:
Calculate NPV and IRR and advice the company whether to purchase the new
ferry or renovate the old ferry?

Q 16 Law plc is a food manufacturing company that is currently searching for new products.
The research and development department has suggested that it should diversify into the
production of frozen ‘ready meals’ beginning with a range of frozen curries. The research
and development department has already spent Rs 50,000 on recipe development and a further
Ra 100,000 on test marketing the proposed range. Initial results of the test marketing suggest
that the company could sell 100,000 meals per year in the first two years rising to 200,000 in
years 3, 4 and 5. The product life is anticipated to be five years.
The research and development department has produced a cost card for the proposed range,
all varieties in the range having the same selling price and costs per unit.

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 Per meal
Selling price 3.00
Direct materials (note 1) (0.80)
Direct labour (note 2) (0.60)
Variable overheads (note 3) (0.30)
Allocated fixed overheads (note 4) (0.50)
Profit 0.80
Notes
(1) All raw materials will be bought in as required for the new range.
(2) This represents 10 minutes’ direct labour per meal at Rs 3.60 per hour. The firm’s
workforce has negotiated an agreement, which guarantees them 40 hours’ pay per
week. This agreement expires in one year’s time. Currently a large part of the
workforce is idle and workers who are currently idle would perform the work for the
new range. In one year’s time the company intends to terminate the guaranteed 40-
hour week agreement and simply pay workers for hours worked. This will require the
firm to increase wages to Rs 4.20 per hour. By transferring workers to work on the new
range it is estimated that redundancy costs of Rs 20,000 will be saved in one year’s time.
(3) This represents electricity and gas to power the cookers and freezers and varies in line
with direct labour hours worked.
(4) This includes Rs 0.10 per hour depreciation, the remainder being an allocation of
general factory overhead. It is estimated that cash fixed overheads will increase by
Rs 30,000 per annum as a result of introducing the new range.
(5) The new range will be cooked and frozen on machinery that is currently standing idle.
This machinery could be currently sold for Rs 100,000, receivable immediately. If used
to produce the new range it has an estimated scrap value of Rs 20,000 in five years’
time. A new packaging machine will be required for the new range costing Rs 500,000
with an estimated scrap value in five years’ time of Rs 40,000. The firm uses straightline
depreciation on all equipment.
Law plc can raise finance at a cost of 12% per annum
Required:
(a) Calculate the net present value of the proposed investment in the new range (to the
nearest Rs 000) and recommend whether it should be accepted. (15 marks)
(b) Calculate the internal rate of return of the project. (5 marks)
c) Using the net cash flows you have calculated in part (a) calculate the payback period
for the project. Advise whether the project should be accepted if the company requires
a payback period of three years for all projects. (5 marks)
Answer NPV 70,000. IRR 16.44%)

5 NPV or IRR?
Both NPV and IRR are superior methods for appraising investments compared to the
techniques covered in the previous chapter because:
(a) they account for the time value of money (unlike ROCE and payback)
(b) they focus on relevant cash flows (unlike ROCE)
(c) they look at the cash flows over the whole life of the project (unlike payback)

By examining the advantages and disadvantages of IRR (NPV has the opposite pros and
cons) as a DCF technique, it can be shown that NPV is the superior technique.

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Advantage of IRR
IRR gives the % return of a project; this concept is easy for non financial managers to
understand and for financial managers to calculate because it does not require the
calculation of a cost of capital.
Disadvantages of IRR
1) Mutually exclusive projects : A smaller project might be chosen over a larger project because
it has a higher IRR. NPV would choose the larger project because it deals in amount not %.
2) A change in direction of the cash flows : If there is another year of negative cash flows, there
may be more than 1 IRR. This means that IRR becomes confusing.
3) Reinvestment assumption : The IRR method assumes that cash inflows from the
project are reinvested at the IRR rate, this is unrealistic when the IRR is high.
Conclusion - NPV is a better technique

NPV does not have any of the problems of IRR. The role of IRR is to act as a tool for
explaining the benefits of an investment to non-financial managers; it should not be used as
the financial analysis used to justify the investment decision.
This is not to say that NPV is perfect; like any financial technique, there is the danger that
the non-financial benefits of an investment are ignored.

Q.17 AH Company is evaluating two alternative mutually exclusive methods of improving the
marketing of its products which it has described as project X and project Y. The estimated
incremental cash flows from each alternative are as follows
Year 0 Year 1 Year 2 Year 3
Project X (700,000) 343,000 343,000 343,000
Project Y (120,000) 552,000 552,000 552,000
The company’s estimated cost of capital is 10%.
Required:
a) Calculate NPV and IRR of both project
b) Based on you answer of a above, discuss which method is better in
selecting mutually exclusive projects.

Q.18 Quick Freeze Foods produces a range of convenience processed foods for a number of
supermarket chain stores. Its success has been based on the expertise and customer-driven
emphasis of its research and development team.
The R & D team has identified three mutually exclusive projects which could be undertaken.
The finance director has recruited you as assistant accountant to carry out a financial
evaluation of each project.
Details of the three projects’ cash flows are shown below:
Indian Chinese Italian
range range range
Cash flow timing Rs '000' Rs '000' Rs '000'
Initial outlay (80,000) (20,000) (20,000)
1 26,500 5,000 12,000
2 26,500 6,000 8,000
3 26,500 8,000 6,000
4 26,500 10,000
Ignore taxation and inflation. Assume that cash flows occur at the ends of each of the years
shown.
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 Required:
(a) Using each of the following appraisal methods rank the projects in order of their
investment potential.
(i) net present value (NPV) at 10% (6 marks)
(ii) approximate internal rate of return (IRR). (8 marks)
(b) (i) Critically compare each of the above investment appraisal methods. (4 marks)
(ii) Explain which method you regard as the most useful for project appraisal and
which project you would recommend. (2 marks)

6) Effect of tax
Corporation tax on profits
Calculate the taxable profits (before tax depreciation) and calculate tax at the rate given.
The effect of taxation will not necessarily occur in the same year as the relevant cash flow
that causes it. Follow the instructions given in exam question.
Tax Depreciation
Calculate the amount of tax depreciation claimed in each year
Make sure that you remember the balancing adjustment in the year the asset is sold
Calculate the tax saved, noting the timing of tax payments given in the question
Cost of Capital
The cost of capital will also be affected by taxation, because debt finance becomes cheaper.

7) Working capital
Major projects will need the injection of funds to finance the level of working capital required
(normally assumed to be stock). Discounted cash flow techniques will account for the
opportunity cost of capital involved.

Questions will show the total amount of working capital required in each year of the project.
The DCF working should only show the incremental cash flows from one year’s requirement
to the next.

At the end of the project, when there is no further requirement for working capital in the project,
the full amount invested will be released. This is shown in the DCF calculation as an inflow.

Q 19 Quitongo plc is considering a major investment program which will involve the creation
of a chain of retail outlets throughout the United Kingdom.
The following schedule of expected cash flows has been prepared for analysis.
Time 0 1 2 3 4
Rs '000' Rs '000' Rs '000' Rs '000' Rs '000'
Land and Buildings 3,250
Fittings and Equipment 750
Gross Revenue 1,000 1,750 2,500 3,200
Direct Costs 800 1,100 1,500 1,600
Marketing 170 250 200 200
Office Overheads 100 100 100 100
Cumulative Working
capital requirement 250 300 375 400
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 Quitongo plc has an accounting year end of 31 December.
Additional information:
(a) 40% of office overhead is an allocation of head office operating costs.
(b) The cost of land and buildings includes Rs 120,000 which has already been spent on
surveyors’ and other advisers’ fees.
(c) Quitongo plc expects to be able to sell the chain at the end of year 4 for Rs 4,500,000.
(d) Cost of capital is 7%
Quitongo plc expects the following working capital requirements during each of the four
years of the investment programme. (All figures in Rs ’000s)
Year 1 Year 2 Year 3 Year 4
250 300 375 400
Quitongo plc is paying tax at 30% and is expected to do so for the foreseeable future.
Tax is payable one year after profits are earned.
The company will claim tax depreciation on fittings and equipment at 25% on a reducing
balance basis. Tax depreciation are not available on land and buildings.
Expenditure on the investment program will take place in January.
Estimated resale proceeds of Rs 200,000 for the fittings and equipment have been included
in the total figure of Rs 4,500,000 given above.
Required
Calculate NPV, IRR, and Payback period of the project

Q.20 Hilton plastics uses a plastic molding machine with a present book value of
(May Rs.2,500,000. The company is producing a single product, cost data is as under:
2008) Rs. / Unit
Direct Material 125
Direct Labour 225
Overheads -variable 75
Fixed overhead Rs.650,000 per annum excluding non-cash items for production
upto 20,000 unit. It will increase by Rs.100,000 per annum from 20,000 to 24,000
units. The company estimates its future production at 22,000 units per annum for
the next five years. The sale price of the machine at the end of 5th year is
Rs.50,000. If the machine is sold today, the sale price will be Rs.1,750,000 net. A
proposal for replacement of the said machine with a more sophisticated machine
is under consideration. The data relating to the new machine are:
Rupees
Purchase price 6,500,000
Operating costs:
Direct material and direct labour 290 per unit
Variable overheads 60 per unit
Fixed overheads consisting of only cash items Rs.1,050,000 per annum upto
25,000 units. Value at the end of 5th year of life is Rs.1,500,000. Rate of
depreciation 10% per annum. Rate of Income Tax 50%.
Required:
(a) Determine the cost per unit on absorption cost basis for the first year of
manufacturing the product on the old and new machines by taking
depreciation on straight line method.

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 (b) Prepare a cash flow statement using old machine for five years by taking the cost
of capital at 12% and determine the excess present value of total cash flows. Use
reducing balance method of depreciation for tax purpose.
(c) State with reasons whether the replace implemented or not.

Q.21 Omega Limited (OL) is the sole distributor of goods produced by ABC Limited which is a
leading brand in the international market. OL is now planning to establish a factory in
collaboration with ABC Limited. The factory would be established on a land which
was purchased at a cost of Rs. 20 million in 2005. The existing market value of the land is
Rs. 40 million. The cost of factory building and plant is estimated at Rs. 30 million and
Rs. 100 million respectively.
The factory will produce goods which are presently supplied by ABC Limited. The
sale for the first year of production is estimated at Rs. 300 million. The existing
profit margin is 20% on sales. As a result of own production, cost per unit would
decrease by 10%. The sale price and cost of production per unit (excluding depreciation)
are expected to increase by 10% and 8% respectively, each year.
Following further information is available:
a) ABC Limited would assist in setting up of the factory for which it would be paid an
amount of Rs. 10 million at the time of signing the agreement. In addition, ABC Limited
would be paid a royalty equal to 3% of sales.
b) The factory building and installation of plant would be completed and commercial
production would start one year after signing the agreement.
c) 50% of the cost of plant would be financed through a five year loan with interest
payable annually at 10% per annum. Principal would be repaid at the end of 5th year.
d) A working capital injection of Rs. 15 million would be required at the commencement
of commercial production.
e) OL charges depreciation on factory building and plant under the straight line method.
f) OL uses a five year project appraisal period. The residual value of the factory building
and plant after five years is estimated at 50% and 10% of cost respectively.
g) The market value of the land after five years is estimated at Rs. 70 million.
h) OL’s cost of capital is 12%.
Required:
Calculate the net present value of the project assuming that unless otherwise specified,
all cash inflows/outflows would arise at the end of year. Ignore taxation.
(Answer NPV 302m)

Q.22 Sona Limited (SL) is considering investment in a joint venture. The entire cash
outlay of the project is Rs. 175 million which would require to be invested by SL
immediately. The joint venture partner, Chandi Limited (CL) would provide all the
necessary technical support.
The other details of the project are estimated as follows:
(i) The project would extend over a period of four years.
(ii) Sales are estimated at Rs. 155 million per annum for the first two years and
Rs. 65 million per annum during the last two years.
(iii) Cost of sales and operating expenses excluding depreciation would be 50%
and 10% of sales respectively.
(iv) CL would be entitled to share equal to 5% of sales and the remaining profit

15
 of the invested amount.
Assume that all cash flows other than the initial cash outlay arise annually in arrears.
Required: Calculate the project’s internal rate of return.
(Answer IRR 14.58%)

Q.23 Tropical Juices (TJ) is planning to expand its production capacity by installing a plant in a
building which is owned by TJ but has been rented out at Rs. 6 million per annum. The
relevant details are as under:
(i) The cost of the building is Rs. 40 million and it is depreciated at 5% per annum.
(ii) The rent is expected to increase by 5% per annum.
(iii) Cost of the plant and its installation is estimated at Rs. 60 million. TJ depreciates
plant and machinery at 25% per annum on a straight line basis. Residual value of the
plant after four years is estimated at 10% of cost.
(iv) Additional working capital of Rs. 25 million would be required on commencement of
production.
(v) Selling price of the juices would be Rs. 350 per litre. Sales quantity is projected as
under:
Year 1 Year 2 Year 3 Year 4
Litres 250,000 300,000 320,000 290,000
(vi) Variable cost would be Rs. 180 per litre. Fixed cost is estimated at Rs. 100 per litre
based on normal capacity of 280,000 litres. Fixed cost includes yearly depreciation
amounting to Rs. 16 million.
(vii) Rate of inflation is estimated at 5% per annum and would affect the revenues as well
as expenses.
(viii) TJ's cost of capital is 15%.
Required:
Compute net present value (NPV) of the project and advise whether it would be feasible to
expand the production capacity. (Assume that all cash flows other than acquisition of plant
and additional working capital would arise at the end of the year)
(Answer NPV 26.45m)

Q.24 Diamond Investment Limited (DIL) is considering to set-up a plant for the production of a
single product X-49. The details relating to the investment are as under:
(i) The cost of plant amounting to Rs. 160 million would be payable in advance. It
includes installation and commissioning of the plant.
(ii) Working capital of Rs. 20 million would be required at the commencement of the
commercial operations.
(iii) DIL intends to sell X-49 at cost plus 25% (cost does not include depreciation on
plant). Sales for the first year are estimated at Rs. 300 million. The sales quantity
would increase at 6% per annum.
(iv) The plant would be depreciated at the rate of 20% under the reducing balance
method. Tax depreciation is to be calculated on the same basis. Estimated residual
value of the plant at the end of its useful life of four years would be equal to its
carrying value.
(v) Tax rate is 34% and tax is payable in the year the liability arises.
(vi) DIL’s cost of capital is 18%. All costs and prices are expected to increase at the rate
of 5% per annum.

16
 Required:
Compute the following:
(a) Net present value of the project (12)
(b) Internal rate of return of the project (05)
Assume that unless otherwise specified, all cash flows would arise at the end of the year.
(Answer NPV 75.76m IRR 20.45%)

Q.25 Digital Electronics (DE) acquired a plant on 1 January 2016 under a lease arrangement
on the following terms:
Lease period (commencing from 1 January 2016) 3 years
Down payment on commencement of lease Rs. 2.00 million
Lease installments payable annually in arrears Rs. 3.90 million
Amount payable on expiry of the lease term Rs. 0.89 million
On the date of acquisition, fair value of the plant was Rs. 10 million. DE depreciates its
property, plant and equipment over their useful life. The disposal price of the plant at the
end of the useful life of four years is estimated at Rs. 0.50 million.
Net cash inflows from the use of the plant are estimated as under:
Year 2016 2017 2018 2019
Amount (Rs. in million) 5.90 5.20 2.45 1.00
It may be assumed that all cash inflows arise at the end of the year.
Required:
Compute internal rate of return (IRR) and advise whether it is feasible to acquire the plant
assuming that DE’s cost of capital is 15%.
(Answer IRR 16.67%)

Q.26 Badger plc., a manufacturer of car accessories is considering a new product line. This
project would commence at the start of Badger plc.’s next financial year and run for
four years. Badger plc.’s next year end is 31st December 2012.
The following information relates to the project:
A feasibility study costing Rs.8 million was completed earlier this year but will not be paid
for until March 2013. The study indicated that the project was technically viable.

Capital expenditure
If Badger plc. proceeds with the project it would need to buy new plant and machinery
costing Rs.180 million to be paid for at the start of the project. It is estimated that the new
plant and machinery would be sold for Rs.25 million at the end of the project.
If Badger plc. undertakes the project it will sell an existing machine for cash at the start
of the project for Rs.2 million. This machine had been scheduled for disposal at the end
of 2016 for Rs.1 million.

Market research
Industry consultants have supplied the following information:
Market size for the product is Rs.1,100 million in 2012. The market is expected to
grow by 2% per annum.

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 Market share projections should Badger plc. proceed with the project are as follows:
2013 2014 2015 2016
Market share 7% 9% 15% 15%
Cost data: (Rs in million)
Purchases 40 50 58 62
Payables (at the year-end) 8 10 11 12
Payments to sub-contractors, 6 9 8 8
Fixed overheads (total for Badger plc)
With new line 133 110 99 90
Without new line 120 100 90 80

Labour costs
At the start of the project, employees currently working in another department would
be transferred to work on the new product line. These employees currently earn
Rs.4 million. An employee currently earning Rs.2 million would be promoted to work
on the new line at a salary of Rs.3 million per annum. A new employee would be
recruited to fill the vacated position.
As a direct result of introducing the new product line, employees in another department
currently earning Rs.4 million would have to be made redundant at the end of 2013
resulting in a redundancy payment of Rs.6 million at the end of 2014.

Material costs
The company holds a stock of Material X which cost Rs.6.4 million last year. There is
no other use for this material. If it is not used the company would have to dispose of it
at a cost to the company of Rs.2 million in 2013. This would occur early in 2013.
Material Z is also in stock and will be used on the new line. It cost the company
Rs.3.5 million some years ago. The company has no other use for it, but could sell it on
the open market for Rs.3 million early in 2013.

Further information
The year-end payables are paid in the following year.
The company’s cost of capital is a constant 10% per annum.
It can be assumed that operating cash flows occur at the year end.
Time 0 is 1st January 2013 (t1 is 31st December 2013 etc.)
Required
Calculate the net present value of the proposed new product line .
(Answer NPV 14m)

Q 27 Your company is trying to decide whether to outsource its packing operations or continue to
Feb do it in-house. The current packing machine would not do anymore; it either has to be sold or
2014 thoroughly fixed up. Following two alternatives are available for packing operations:

Other details about the two alternatives are as under:

Rs.10 million only.

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 Doing the packing in-house requires an investment of Rs.20 million to fix up the existing
packing machine. For tax purposes this amount will be added in WDV and depreciated
annually at the rate of 10% of WDV. Given this investment, the machine will be good for
another five years but have no salvage value after 5 years. No tax depreciation will be
allowed in year-5 and WDV at the end of year-4 will be allowed as tax loss on disposal.
The relevant discount rate is 12%.
Required:
(a) Calculate Net Present Value (NPV) for the following options:
(i) In-house packing. 14
(ii) Outsourcing. 04
(b) (i) Advise better option and briefly state reasons thereof. 01
(ii) Briefly state other factors that should be considered while opting best option. 01

Q 28 Texfab Textiles has received an offer from local Power Generation firm to provide
Feb breakdown free power supply for longer term. The equipment and installations of
2013 transmission line would cost Rs. 5,000,000. Management believes that the power supply
would provide substantial annual reductions in costs, as shown below:
Rupees
Electricity cost 695,000
Power breakdown cost 555,000
The new power system would require considerable maintenance work to keep it in
proper adjustment. The company engineers estimate that maintenance cost would
increase by Rs. 16,000 per annum if new system operates. The transmission system
needs an overhaul at the end of every 2 years amounting to Rs. 200,000 per overhaul.
The contract period would be 10 years with salvage value (of installations) of
Rs. 70,000. After 10 years company will be able to purchase a new power generation
system from an international supplier amounting to Rs. 30 million.
Texfab Textiles requires a rate of return before tax of at least 18% on investment and
uses straight-line deprecation method.
Required:
(i) Should Texfab Textiles accept the offer or not? Ignore taxation. 08
(ii) Should Texfab Textiles accept the offer or not, if taxation rate is 35%? 08
(Support your answers with proper working)

Q 29 An organization is considering to purchase a machine for Rs. 150,000. It would be sold

Sept after six years for an estimated realizable value of Rs. 50,000. Capital allowance of
2013 Rs. 120,000 would be claimed at Rs. 30,000 per year in four years. The rate of corporation
tax is 30% and after tax cost of capital is 14%. The machine would earn profits before tax
of Rs. 25,000 a year. Depreciation charge would be Rs. 20,000 a year for six years.
Assume the tax payments are made half in the same year and half in the following year.
Required:
(i) Calculate annual incremental after tax cash flows. 05
(ii) Calculate the net present value (NPV) of the proposal to acquire the machine. 05
(iii) Calculate internal rate of return (IRR) of the project. 03

19
Q 30 Weavers Ltd is engaged in the manufacture of carpets and is considering an expansion of
production facilities to meet an anticipated increase in demand over the next five years. The
board of directors is currently considering two mutually exclusive options.
The first option is to acquire an additional loom.
(i) The loom will have an initial cost of £800,000 and will have a life of five years. At
the end of year five it will have a zero scrap value.
(ii) The loom will produce an additional 1,000 carpets per annum for the next five years.
(iii) The sales price of each carpet is £1,000 which has been fixed for the next five years by
Government price control.
(iv) Each carpet produced by this loom requires:
(1) Material costing £400.
This will remain constant for the next five years.
(2) Direct labour of 10 hours at £10 per hour in year one.
For each of the subsequent four years, pay will increase by 2% of the preceding
year’s level.
(3) Machine time of 20 hours at £10 per hour.
This will remain constant for the next five years.
(v) Depreciation is on a straight line basis.
The second option is to subcontract production of an additional 1,000 carpets per annum
under a fixed contract for the next five years.
(i) There is an annual subcontract fee payable at the end of each of the next five years
commencing at the end of year one at £150,000. For each of the subsequent four years
this fee will increase by 5% of the preceding year’s level.
(ii) Over the next five years the subcontractor has agreed to produce and deliver up to a
maximum 1,000 carpets each year to the company for an agreed cost per carpet of
£700 (in addition to the annual fee in (i)).
(iii) The sales price of each carpet is £1,000 which has been fixed for the next five years by
Government price control.
(iv) Under the contract Weavers Ltd must agree to accept a minimum of 750 carpets pa
(v) Weavers Ltd has already spent £100,000 conducting research into the viability of this
subcontract arrangement.
The cost of capital is 10%.
Ignore taxation.
Required:
(a) Calculate the net present value of each of the options to the nearest £000. (18 marks)
State clearly any assumptions made.
(b) (i) On the basis of the calculation made in (a) above, which of the two options
would you choose and why? (2 marks)
(ii) Briefly outline four key factors which should be considered before a final
decision is reached. (4 marks)
(c) (i) Explain why it is important to carefully evaluate capital investment decisions.
(4 marks)
(ii) Identify and discuss the key stages in the capital investment appraisal decision
making and control cycle. (10 marks)
(iii) Outline two key advantages of auditing the performance of a capital investment
project. (2 marks

20
Q 31 Gold Club Ltd is a newly established company that has not yet commenced trading. The two
shareholders/directors are planning to set up an Internet business. With the help of finance
from venture capitalists, they plan to set up a website through which individuals can join a
‘Gold Club’. Membership of the club will provide members with a range of quality travel
services including access to a First Class lounge at airports, travel insurance for an unlimited
number of trips and discounted upgrades for seats on flights. It will take one year to set up
the business.

You are an accounting technician who has been asked to appraise the investment of capital in
the project based on a six-year plan (one year to set up the business followed by five years of
operation).

(i) Market research has been carried out at a cost of £200,000. This indicates that the
number of new members joining the club would be approximately 5,000 each year. Of
these new joiners each year, 50% will renew their membership ONCE, in the
following year.
(ii) Membership fees for new members joining the club each year will be £500. Members
renewing their membership in the subsequent year will benefit from a reduced annual
fee of £400.
(iii) The costs of setting up the website are as follows:
– Design costs: £1,220,000
– Administrative costs: £125,000
– Legal advice fees: £155,000
25% of these costs will be paid immediately as a deposit, with the remainder being
paid in one year’s time.
(iv) The costs of the technical support for maintaining the website will be £100,000 for the
first year it is in operation. These costs will increase by 20% year-on-year thereafter.
(v) All new members will be issued with a club card, with an electronic chip in it. The
cost of this card for Gold Club Ltd will be £3 per member. Once the original card is
issued, there will be no need to issue a further card for renewal of membership. The
supplier will be paid annually in arrears for all cards issued in that year. The first
payment is therefore due at the end of the second year.
(vi) For every member who uses a First Class lounge at any airport worldwide, a charge of
£20 will be made to Gold Club Ltd each time the lounge is used. It is estimated that
40% of members will use it three times a year, 30% of members will use it twice a
year, 20% will use it once a year and 10% will not use it at all.
(vii) Gold Club Ltd will purchase a travel insurance policy based primarily on the number
of members in the scheme. It is assumed that all members will make use of the travel
insurance and the supplier will therefore charge Gold Club Ltd £50 per member in the
first year, increasing steadily by £2 per member each year after that. Each member
will have to e-mail the travel insurers with details of their trip in advance of each trip.
Therefore, the insurers will also charge Gold Club Ltd an administrative fee of £2 for
every e-mail received. Gold Club Ltd estimates that on average each member will
send two e-mails per annum.
(viii) Gold Club Ltd will pay ten major airlines £100,000 EACH per annum in order to
provide their members with access to discounted seat upgrades.
(ix) Overdraft interest will be £5,000 per annum.

21
 (x) Assume that all cash flows, including the receipt of membership fees, occur at the end
of each year, unless otherwise stated.
(xi) The company’s cost of capital is 10% per annum. (xii) Workings should be in £’000,
to the nearest £’000.

Required:
Using the discount tables provided at the end of the question, calculate the project’s
net present value (NPV) at the company’s cost of capital. Conclude as to whether the
company should proceed with the project, giving a reason for your conclusion.

Q 32 Maybay Hospital is a private hospital. Currently, all cleaning is undertaken by staff

employed by the hospital. There are 150 cleaning staff in total, of which half work full-time
and half work part-time. Over the last year there has been a serious outbreak of the
MRSA bug (a bacterial infection resistant to antibiotics) in the hospital. Cleaning standards
have therefore become a key issue. The hospital is currently being sued by a group of
patients who are all claiming to have suffered from MRSA following admittance to Maybay.
This has caused a significant fall in the number of patient admissions and an increase
in the hospital’s insurance costs. The hospital managers are now considering whether
they should continue with their existing cleaning staff (Option 1) or contract out the
cleaning function to external providers for the next five years (Option 2). The following
information has been provided:

1 Full-time cleaning staff work 35 hours a week and are paid £5·70 per hour.
2 Part-time cleaning staff work a 20-hour week and are paid £5·65 per hour.
3 Eight full-time supervisors are also employed, in addition to the cleaning staff, at a
salary of £15,000 per annum each.
4 Other staff costs, including pension costs, average £2,625 per annum per full-time
employee (including supervisors) and £1,215 per part-time employee.
5 If the cleaning continues to be done by hospital cleaners, it has already been decided
that 10 new full-time cleaners will be employed immediately. The hospital will also
recruit a further 15 full-time cleaners in one year’s time.
6 Total insurance costs for the whole hospital are currently £6·5 million per annum. The
hospital estimates that these will fall immediately by 10% if the cleaning is contracted
out to an external provider. They will remain the same if the cleaning is NOT contracted out.
7 Cleaning materials cost £1·44 million per annum. If an external provider is used in the
future, they will provide their own cleaning materials.
8 Independent inspectors inspect hospital hygiene standards every six months. Breaches
of standards fall into one of two categories: serious breaches, for which a fine of
£10,000 per breach is imposed, and minor breaches, for which a fine of £2,000 per
breach is imposed. If the hospital does NOT contract out its cleaning, but the new
cleaners are employed, it is estimated that serious breaches can be limited to 22
per year and minor breaches can be limited to 74 per year. The external providers
expect to restrict these breaches to 17 and 50 respectively in the first year, falling to
8 and 25 respectively per year thereafter. Even with a contracted out cleaning service,
the hospital will continue to be responsible for all payments of fines.

22
9 The hospital has invested heavily in floor polishing machines over recent years, and
currently has 150 in total. The external providers have offered to buy these immediately
at a price of £4,000 each, should the contracting out go ahead.
10 Adverse publicity resulting from the MRSA bug is costing the hospital £1·2 million
per annum in lost contribution. The external cleaning providers’ reputation is such that
this amount can be totally eliminated immediately.
11 The external providers have offered to provide cleaning services for a contracted
five-year period. The fees will be £4·25 million for each of the first two years, increasing
to £4·5 million per annum thereafter.
12 Administration costs are currently £300,000 per annum. They would fall to £270,000
per annum if the cleaning were contracted out.
13 If the hospital decides to contract out the cleaning, it will be with immediate effect.
A redundancy package has been put together for current staff. Each full-time employee,
including supervisors, will receive an average of £5,000 and each part-time employee
will receive an average of £3,000. These amounts will be payable immediately.
14 The hospital managers have spent £60,000 researching and calculating their costs.
15 The hospital’s cost of capital is 10% per annum.
16 Assume that all cash flows occur at the end of each year unless told otherwise.

Required:
Calculate the net present values of the costs of each of the two options above.
Recommend whether the hospital should continue with its existing staff (Option 1)
or contract out of cleaning for the next five years (Option 2). (30 ma

23