Investment Appraisal-Problem and solution. you can study. PDF

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Financial Management is a very important chapter to pass if you want to pass u should study more details on the subject for your passing probability....

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Example-01: Inflation & Taxation: ZAO Pvt. Ltd. is a world famous toy maker established its manufactures its manufacturing plant in Bangladesh. Recent market research shows they have an increasing demand for a new product called “Magic Toy”, which is used by kids below 7 years old. You are the management Accountant of ZAO Pvt. Ltd. and your CEO asked you to make the evaluation about the purchase of a new machine to produce Magic-Toy, which has a short product life cycle due to rapidly changing technology by using the project appraisal Methods. The Purchase price along with other installation cost of the machine is established BDT. 900 Million. Marketing department has given the following estimation of Production and sales of Magic-ToyYear 2018 Production & Sales (units)-million 3.5

2019 5.3

2020 7.5

2021 3.6

2022 1.5

The selling Price of Magic-Toy is forecasted as BDT. 1210 per unit, Materials Cost will be BDT. 700 per unit; Labor and other variable cost of the production (in first year) will be BDT. 360 per unit. Selling price inflation is expected to be 6% p.a. and variable cost inflation is expected to be 7% p.a. No increase is existing fixed costs is expected. Producing and selling Magic-Toy- will call for increased investment in working capital .Analysis indicates that at the start of each year, investment in working capital for Magic-toy will need to be 5% of sales revenue for that year. ZAO Pvt. Ltd. pays tax of 45% 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 the company can claim on a straight-line basis over the five years of life of the proposed investment. The new machine is expected to have no salvage value at the end of the four-year period; rather there will be a dismantling cost of BDT. 2 million as the machine needs to be broken in to pieces before it’s thrown out of the factory. The Company uses a nominal (money terms) after-tax cost of capital of 16% for investment appraisal purposes. Required: i. ii. iii.

Calculate the NPV of the proposed investment in the new machine for Magic-Toy. Calculate the IRR of the proposed investment in the new machine for Magic-Toy. Recommend on the acceptability of the proposed investment in the new machine for MagicToy and discuss the Limitations of the evaluations you have carried out.

Example-03-Inflation & Taxation: The Management of a hotel is considering expanding its facilities by providing a gymnasium and spa for the use of guests. It is expected that the additional facilities will result in an increase in the occupancy rate of the hotel and in the rates that can be charged for each room. The cost of refurbishing the space, which is currently used as a library for guests, and installing the spa is estimated to be Tk. 100,000. The cost of the gymnasium equipment is expected to be Tk. 50,000. The gymnasium and spa will need to be refurbished and the equipment replaced every four years. The equipment will be sold for tk. 15,000 cash at the end of year 4. This amount includes the effect of inflation. The Hotel’s accountants have produced a feasibility report at a cost of Tk. 10,000. The key findings from their report, regarding occupancy rates and room rates are as follows: • Current occupancy rate: 80% • Number of rooms available: 40 • Current average room rate per night: Tk. 250 Occupancy rates following the opening of the gymnasium and spa are expected to rise to 82% and the average room rate by 5%, excluding the effect of inflation.  The hotel is open for 360 days per year Other relevant information from the accountant’s report is listed below: 1. Staffing the gymnasium and Spa: Number of Employees: 4 Average salary of employee; Tk. 30,000 per annum. 2. Overheads:

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The Current budgeted overhead absorbed rate for the hotel is Tk. 80 per square meter per annum.

The hotel’s overheads are expected to increase by Tk. 42,000 directly as a result of opening the gymnasium and spa. 3. Inflation:

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Inflation is expected to be at a rate of 4% per annum and will apply to sales revenue, overhead costs and staff costs. The rate of 4% will apply from Year 2 to each of the subsequent years of the projects. 4. Taxation: The Hotel’s accountants have provided the following taxation information.  Tax depreciation available on all costs of refurbishing, installation and equipment: 25% reducing balancing Method per annum.  Taxation rate: 30% of taxable profit. Half of the tax is payable in the year arises & the balance is payable in the following year.  Any losses resulting from this investment can be set against taxable profits made by the company’s other business activities. The Company uses a post-tax money cost of capital of 12% per annum to evaluate projects of this type. Required: a) Calculate the NPV of the gymnasium and spa projects b) Calculate the post-tax money cost of capital at which the hotel would be different to accepting/rejecting the project. c) Discuss the alternative method for the treatment of inflation that would result in the same NPV Your Answer should consider the potential difficulties in using this method when taxation is involved in the project appraisal.

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Examples 02- Project Selection: A Bus operator has been experiencing a fall in passenger numbers over the past few years as a result of intense competition from other transport provides. The company directors are concerned to improve profit and are considering two possible alternatives. Passenger volume last year was 20,000 passengers per day. The average fare was Tk. 2 per passenger per day and variable cost per passenger per day was Tk. 0.50. If no investment is made the current passenger volume, average fares and variable costs will remain the same on current routes for the next 5 years. The company operates a full service for 65 days of the year. Project-1 The company hired a management consultant, at a cost of Tk. 50,000 to review the company’s fare structure. The consultant recommended that the company reduce fares by 10% which will result in a 20% increase in passenger volume in the first year.in order to maintain this level of passenger numbers, fares will remain at the reduced rate for years 2 to 5. The increase in passenger numbers will result in the need four new buses costing Tk. 250,000 each. The new buses will be depreciated on a straight line basis over their useful life 5 years. They will have no residual value at the end of their useful life. Other annual fixed costs , including advertising costs, will increased by Tk. 100,000 in the first year and will remain at that level for the life of the project. Variable costs will remain at Tk. 0.50 per passenger per day for the life of the project. Project-2 Increase the Number of buses to enable new routes to be opened. The new buses are expected to cost Tk. 500,000 in total and have a useful life of five years with no residual value. Fixed costs, including straight line depreciation, are expected to increase by Tk. 3500,000 in the first year, as a result of opening the new routes. Fixed costs, will remain at the higher level for the life if the project. Additional working capital of Tk. 1,000,000 will also be required. The passenger number for year 1 on the new routes is predicted as follows: Passenger Numbers per day Probability 6,000 50% 9,000 30% 12,000 20% It is expected that passenger numbers will increase by 3% per annum for the following four years. The average fare per passenger for year 1 will be Tk. 2 and will remain at that level for the life of the project. Variable Costs will remain at Tk.0.50 per passenger per day for the life of the project. Additional Information: Taxation & inflation should be ignored. The Company uses a cost of Capital of 8% per annum. Required: a. Advice the management of the company which project should be undertaken based on a financial appraisal of the projects.(Use NPV Technique) b. Explain two other major factors should be considered before a final decision is made. c. Calculate the sensitivity of the choice between project 1 and project 2 to a change in passenger numbers for project 2. d. Company D is planning its capital investment program for next year. It is considering four potential projects all of which have a positive NPV. The initial investment, IRR and NPV, based on a cost of capital of 12%, are given below for each project. Project Investment Tk. 000 NPV at 12% IRR A 50 13.6 12.6% B 40 15.2 10.3% C 20 10.2 13.1% D 30 12.3 11.2% Funding for the company is restricted to Tk. 110,000. The projects are in depended and divisible; part of a project can be undertaken. Required: Priorities the projects and determine how much funding should be allocated to each project....