INVESTMENT APPRAISAL
Question 01
Mlimba Manufacturing is a well-established company specializing in producing highquality
charcoal stoves. As part to its continuous improvement efforts, the company is considering the
purchase of a new machine to enhance its production capabilities. A market research survey,
conducted at a cost of TZS.2,000,000, predicts demand of 4,000 stoves per annum at a selling
price of TZS.7,500 per stove for 10 years. The machine will cost TZS.20,000,000 payable in two
instalments, with the first installment of TS.10,000,000 payable at the beginning of operations and
the second installment of TZS.10,000,000 payable at the end of the second year. Depreciation of
TZS.1,800,000 per annum over the next 10 years will be provided to write down the machine to its
scrap value of TZS.2,000,000. One existing equipment which originally cost TZS.1,500,000, has a
book value of TZS.750,000 and would cost TZS.2,000,000 to replace. Mlimba is currently
negotiating the sale of this equipment for TZS.1,000,000. Variable cost per stove will be
TZS.6,000, and in accordance with the company policy, TZS.2,500,000 of fixed overhead will be
apportioned to the new product line per annum. The machine will require its first service one year
after purchase, and from there onwards will be serviced every year. Each service costs
TZS.500,000. The machine will be brought into use immediately to build up inventory, but the
first revenues will not be received until the end of the second year. Variable costs are payable
annually at the same time as the revenues are received.
REQUIRED: Calculate the following:
(i) Return On Capital Employed (ROCE) on an initial investment basis. (2 marks)
(ii) Payback period. (3 marks)
(iii) Net Present Value (NPV) at the company’s cost of capital of 15%. (5 marks)
Question 02 NBAA NOVEMBER 2018(Asset replacement for NPV)
MATESO Co. is considering the purchase of a new machine to replace an old one. The purchase
price of the new machine is TZS.74 million and it will require an additional TZS. 6,000,000 to
install, bringing the total cost to TZS.80 million. The old machine which has a remaining useful
life of four years can be sold at its depreciated (tax) book value of TZS. 8,000,000. The old
machine would have no salvage value if held to the end of its useful life. The new machine
should cut labour and maintenance cost and produce other cash totaling to TZS. 28,400,000 a
year before taxes for each of the next four years, after which it will probably neither provide any
saving nor have a salvage value. The corporate tax rate is 40%. Annual depreciation charges for
the old and new machine over the four years are depicted in the table below:
Machine END OF YEAR (figures in millions)
1 2 3 4
New Machine TZS.8 TZS.8 TZS.8 TZS.8
Old Machine TZS.4 TZS.4 0 0
The current Weighted Average Cost of Capital for the firm is 10%. REQUIRED:
Assess the economic viability of the new machine. (10 marks)
Question 03
Warden Company plans to buy a new machine. The cost of the machine, payable immediately, is
TZS.8,000,000 and the machine has an expected life of five years. Additional investment in
working capital of TZS.900,000 will be required at the start of the first year of operation. At the
end of the years, the machine will be sold for scrap, with the scrap value expected to be 5% of the
initial purchase cost of the machine. The machine will not be replaced. Production and sales from
the new machine are expected to be 100,000 units per year. Each unit can be sold for TZS.160 per
unit and will incur variable costs of TZS.110 per unit. Incremental fixed costs arising from the
operation of the machine will be TZS.1,600,000 per year. Warden Co. has an after-tax cost of
capital of 11% which it uses as a discount rate in investment appraisal. The company pays profit
tax one year in arrears at an annual rate of 30% per year. Capital allowances and inflation should
be ignored.
REQUIRED:
(i) Calculate the Net Present Value (NPV) of investing in the new machine and
advise whether the investment is financially acceptable. (7 marks)
(ii) Calculate the Internal Rate of Return (IRR) of investing in the new machine and
advise whether the investment is financially acceptable. (3 marks)
Question 04 (New Asset for NPV)
Debora has undertaken market research at a cost of TZS 2,000,000 in order to forecast the future cash
flows of an investment project with an expected life of four years as follows:
Year
Sales Revenue (TZS000) 12,500 25,700 68,900 45,300
Costs (excluding depreciation) (TZS000) 6,000 6,000 6,000 6,000
These forecast cash flows are before taking account of general inflation of 5% per year. The capital cost
of the investment project is Tzs 20,000,000, payable at the start of the first year, and realizable
value will be 10% of the cost occur at fourth year. The level of working capital investment at the
year of project commencement is expected to be TZS 2,000,000.
Capital allowance would be available on the capital cost of the investment project on a straight line
basis. Debora Co. pays tax on profits at an annual rate of 30% per year, with tax being paid one
year in arrears. Debora Co has a nominal (money terms) after tax cost of capital of 12% per year.
Required:
1. Calculate the next present value of the investment project in nominal terms and comment
on its financial acceptability.
2. Calculate the net present value of the investment project in real terms and comment on its
financial acceptability.
Question 05 (New Asset for NPV)
A company is considering whether or not to invest in a five-year project. The investment will involve
buying an item of machinery for $200,000.
At today’s prices, the annual operating cash flows would be:
Revenues Running costs
200,000 100,000
200,000 100,000
250,000 125,000
150,000 75,000
100,000 50,000
Revenues are expected to go up by 7% each year due to inflation, and costs are expected to go up by
12% per year due to inflation.
The machinery is expected to have a re-sale value at the end of year 5 of
$20,000 at today’s prices, but this amount is expected to rise by 5% each year due to inflation.
The cost of capital is 16%.
Required Calculate the NPV of the investment project and recommend whether the project should be
undertaken
Q2:Galaxy Ltd is located in Miami producing and selling a special yam species called ‘puna’. The
company intends to switch from the traditional harvesting of the yam to a more mechanised
method. It will need $60,000 to acquire a newly designed yam harvesting equipment now. A
Consultant has provided the company with the following data:
Forecast Yea Yea2 Yea Yea Yea
Quantity sold (units) 1,655
1,86 2,60 3,11 1,84
Selling price ($) 10.0
Variable cost/unit ($) 4.00
Total Fixed cost ($) 2,80
Annual Advertising ($) 800
Working capital Balance ($) 2,00 3,200
1,90 4,10 2,60
Replacement parts ($) 1,60 1,960
1,57 2,23 1,78
Additional information:
1) Annual inflation on cash flows has been estimated as follows: selling price is 7%;
variable cost is 3%; and fixed cost is 6%. Salesmen commission is 10% of annual sales.
2) A capital allowance of 25% can be claimed on the equipment which has a scrap value of
$8,500. Capital allowance follows the reducing balance method. The company pays tax
and claims tax benefits at the rate of 25% per annum. Tax is paid 1 year in arrears.
3) Working capital is recovered at the end of the project life.
4) A total of $30,000 has been committed to paying the company’s Consultants who offer
consultancy services on all projects of Galaxy Ltd.
5) The company accepts only projects that pay a return of 13% per annum.
Required:
i) Advise the company on the buying of this equipment. Your decision should be supported
with relevant computations. (11
marks)
ii) Explain TWO (2) limitations of Internal Rate of Return as an investment appraisal
technique. (4
marks)
(Specific decision- Capital rationing)
You are a financial analyst of Orlyn Company. The Board of Orlyn Co. has decided to limit investment
funds to TZS 700 million for the next year and is preparing its capital budget. The company is considering
five projects, as follows:
PROJECT INITIAL INVESTMENT (TZS) NPV IN TZS
A 195,000,000 170,000,000
B 254,000,000 155,500,000
C 200,000,000 105,500,000
D 100,000,000 55,000,000
E 250,000,000 100,000,000
All five projects have a project life of the four years. Projects B and E are mutually exclusive. All Net
Present Values are in nominal, after-tax terms. The Company has a nominal after-tax cost of capital of 10%
per year.
Required:
(i) Compute the maximum Net Present Value which can be obtained from investing the fund of TZS
700 million and formulate and optimal investment schedule assuming all five projects are divisible.
Advise Orlyn Co. on how an optimal investment schedule can be formulated. Assume that the five projects
were indivisible
(Specific decision- Asset Abandonment)
KOBELO Company owns equipment that is already 5 years old and the estimated physical life is no more
than three further years. It is now 31 st December 2016. The equipment can be sold now at its residual value.
The cost of capital for the firm is 10%. Below are the net cash flows and residual value estimates for the
equipment over the next three years:
End of Years Cash Flow (Millions of TZS) Residual Value (Millions of TZS
20162 2024 - 14
2017 2025 10 8
2018 2026 2 1
2019 2027 1 0
A decision is to be made whether to abandon the equipment end of year 2017, 2018 or 2019.
Required:
Evaluate and comment on the appropriate timing of abandoning the equipment
(Specific decision- Asset replacement cycle)
SAFARI Ltd owns a delivery truck that has been in operation for 4 years. The company expects that the
efficiency and operating costs of the truck will change as it gets older. It is now 1 st December 2024 and the
company has the option to either retain the truck for the coming years .
The cost of capital for the firm is 12%, and the company wants to determine the optimal replacement
cycle (i.e., how long to keep the truck before replacement) in order to minimize costs and maximize value.
The following estimates of annual operating cash flows (cost savings) and expected resale (residual) values
are provided:
End o Years Net Cash Flow (Millions of TZS) Residual Value (Millions of TZS
20162 2024 (30) -
2017 2025 10 19
2018 2026 11.5 16
2019 2027 13 6
A decision is to be made whether to replace the equipment end of year 2025, 2026 or 2027.
Required:
Evaluate and comment on the appropriate timing of replacing the equipment
(Specific decision- Lease or buy)
Crimson is considering a project requiring anew machine. The machine costs $3million and it
would have a useful life of three years and no residual value at the end of that time.
The machine will produce cash operating surpluses of $1.6 million each year. Tax allowable depreciation is
15% on a straight-line basis.
Tax is 30% on operating cash flows and is payable one year in arrears. Crimson has an
after-tax cost of capital of 20%.
It is considering either borrowing from the bank at the pre-tax interest rate of 14% and buying the
asset outright, or leasing it at a cost of $1.3 million each year for three years, with the lease
payments payable in arrears at the end of each year.
Required
Evaluate the project. Should the asset be acquired, and if so which financing method should be used?
(Uncertainty environment- sensitivity margin)
Q1:Akili Ltd is considering a project with a life of 4 years. Details of the project include the following.
Outlay (new machine) TZS 275,000,000
Annual sales (units) 1,000,000
Unit selling price TZS 500
Unit variable cost TZS 300
Annual cash fixed cost TZS 60,000,000
Project specific cost of capital 9%
Required:
a) Compute the NPV of the project
b) Measure the sensitivity of the NPV to the various input factor
Q2:Warden Co plans to buy a new machine. The cost of the machine, payable immediately, is $800,000
and the machine has an expected life of five years. Additional investment in working capital of
$90,000 will be required at the start of the first year of operation. At the end of five years, the
machine will be sold for scrap, with the scrap value expected to be 5% of the initial purchase cost
of the machine. The machine will not be replaced.
Production and sales from the new machine are expected to be 100,000 units per year. Each unit can be
sold for $16 per unit and will incur variable costs of $11 per unit. Incremental fixed costs arising
from the operation of the machine will be $160,000 per year.
Warden Co has an after-tax cost of capital of 11% which it uses as a discount rate in investment
appraisal. The company pays profit tax one year in arrears at an annual rate of 30% per year.
Capital allowances and inflation should be ignored.
Required:
(i) Explain briefly the meaning of the term ‘sensitivity analysis’ in the context of investment appraisal;
(i) Calculate the sensitivity of the investment in the new machine to a change in selling
price and to achange in discount rate, and comment on your findings.
Q3:Machange Co is considering investing TZS.50,000,000 in a new machine with an expected life
of five years. The machine will have no scrap value at the end of five years. It is expected
that the machine will produce 20,000 units each year selling at TZS.3,000 per unit. Variable
production costs are expected to be TZS.1,650 per unit, while incremental fixed costs, mainly
the wages of a maintenance engineer, are expected to be TZS.10,000,000 per year. Machange
uses a discount rate of 12% for investment appraisal purposes and expects investment
projects to recover their initial investment within two years.
REQUIRED:
Evaluate the sensitivity of the project’s Net Present Value (NPV) to a change in the following
project variables:
(i) sales volume (2 marks)
(ii) sales price (2 marks)
(iii) variable cost (2 marks)
