38 Calvic Co

27 mins

Cavic Co services custom cars and provides its clients with a courtesy car while servicing is taking place. It has a
fleet of 10 courtesy cars which it plans to replace in the near future. Each new courtesy car will cost $15,000. The
trade-in value of each new car declines over time as follows:
Age of courtesy car (years)
Trade-in value ($/car)

1
11,250

2
9,000

3
6,200

Servicing and parts will cost $1,000 per courtesy car in the first year and this cost is expected to increase by 40%
per year as each vehicle grows older. Cleaning the interior and exterior of each courtesy car to keep it up to the
standard required by Cavic's clients will cost $500 per car in the first year and this cost is expected to increase by
25% per year.
Cavic Co has a cost of capital of 10%. Ignore taxation and inflation.
Required

(a)

Using the equivalent annual cost method, calculate whether Cavic Co should replace its fleet after one year,
two years, or three years.
(10 marks)

(b)

Discuss the causes of capital rationing for investment purposes.

(5 marks)
(Total = 15 marks)

39 Trecor Co (Specimen paper 2007, amended)

27 mins

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:

4% per year

Fixed production overheads:

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
tax allowable depreciation on a 25% reducing balance basis. General inflation is expected to be 5% per year.
Required

Calculate the net present value of buying the new machine and comment on your findings (work to the nearest
$1,000).
(15 marks)

34

Questions

40 Corter Co (Specimen paper 2007, amended)

18 mins

Corter Co plans to buy a machine costing $250,000 which will last for four years and then be sold for $5,000.
Net cash flows before tax are expected to be as follows.
Net cash flow $

T1
122,000

T2
143,000

T3
187,000

T4
78,000

Corter Co has a target return on capital employed of 20%. Depreciation is charged on a straight-line basis over the
life of an asset.
(a)

Calculate the before-tax return on capital employed (accounting rate of return) based on the average
investment and comment on your findings.
(5 marks)

(b)

Discuss the strengths and weaknesses of internal rate of return in appraising capital investments. (5 marks)
(Total = 10 marks)

41 OKM Co (6/10, amended)

27 mins

The following draft appraisal of a proposed investment project has been prepared for the finance director of OKM
Co by a trainee accountant. The project is consistent with the current business operations of OKM Co.
Year
Sales (units/yr)
Contribution
Fixed costs
Depreciation
Interest payments
Taxable profit
Taxation
Profit after tax
Scrap value
Aftertax cash flows
Discount at 10%
Present values

1
250,000
$000
1,330
(530)
(438)
(200)
162
(49)
162

162
0.909
147

2
400,000
$000
2,128
(562)
(438)
(200)
928
(278)
879

879
0.826
726

3
500,000
$000
2,660
(596)
(437)
(200)
1,427
(428)
1,149

1,149
0.751
863

4
250,000
$000
1,330
(631)
(437)
(200)
62
(19)
(366)
250
(116)
0.683
(79)

5
$000

(19)
(19)
0.621
(12)

Net present value = 1,645,000 2,000,000 = ($355,000) so reject the project.

The following information was included with the draft investment appraisal:
(1)

The initial investment is $2 million

(2)

Selling price: $12/unit (current price terms), selling price inflation is 5% per year

(3)

Variable cost: $7/unit (current price terms), variable cost inflation is 4% per year

(4)

Fixed overhead costs: $500,000/year (current price terms), fixed cost inflation is 6% per year

(5)

$200,000/year of the fixed costs are development costs that have already been incurred and are being
recovered by an annual charge to the project

(6)

Investment financing is by a $2 million loan at a fixed interest rate of 10% per year

(7)

OKM Co can claim 25% reducing balance tax allowable depreciation on this investment and pays taxation
one year in arrears at a rate of 30% per year

(8)

The scrap value of machinery at the end of the four-year project is $250,000

(9)

The real weighted average cost of capital of OKM Co is 7% per year

(10)

The general rate of inflation is expected to be 4.7% per year

Questions

35

Required

(a)

Identify and comment on any errors in the investment appraisal prepared by the trainee accountant.
(5 marks)

(b)

Prepare a revised calculation of the net present value of the proposed investment project and comment on
the projects acceptability.
(10 marks)
(Total = 15 marks)

42 CJ Co (12/10, amended)

18 mins

CJ Co is considering an investment project, as follows.

Project A

This project is an expansion of existing business costing $3.5 million, payable at the start of the project, which will
increase annual sales by 750,000 units. Information on unit selling price and costs is as follows:
Selling price:

$2.00 per unit (current price terms)

Selling costs:

$0.04 per unit (current price terms)

Variable costs:

$0.80 per unit (current price terms)

Selling price inflation and selling cost inflation are expected to be 5% per year and variable cost inflation is expected
to be 4% per year. Additional initial investment in working capital of $250,000 will also be needed and this is
expected to increase in line with general inflation.
Other information

CJ Co has a nominal weighted average after-tax cost of capital of 10% and pays profit tax one year in arrears at an
annual rate of 30%. The company can claim tax-allowable depreciation on a 25% reducing balance basis on the
initial investment.
General rate of inflation:

4.5% per year

Required

Calculate the net present value of Project A and advise on its acceptability if the project were to be appraised using
this method.
(10 marks)

43 BRT Co (6/11, amended)

27 mins

BRT Co has developed a new confectionery line that can be sold for $5.00 per box and that is expected to have
continuing popularity for many years. The Finance Director has proposed that investment in the new product should
be evaluated over a four-year time-horizon, even though sales would continue after the fourth year, on the grounds
that cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (both
in current price terms) will depend on sales volume, as follows.
Sales volume (boxes)
Variable cost ($ per box)
Total fixed costs ($)

less than 1 million

2.80
1 million

11.9 million
3.00
1.8 million

22.9 million
3.00
2.8 million

33.9 million
3.05
3.8 million

Forecast sales volumes are as follows.

Year
Demand (boxes)

36

Questions

1
0.7 million

2
1.6 million

3
2.1 million

4
3.0 million

The production equipment for the new confectionery line would cost $2 million and an additional initial investment
of $750,000 would be needed for working capital. Tax-allowable depreciation on a 25% reducing balance basis
could be claimed on the cost of equipment. Profit tax of 30% per year will be payable one year in arrears. A
balancing allowance would be claimed in the fourth year of operation.
The average general level of inflation is expected to be 3% per year and selling price, variable costs, fixed costs and
working capital would all experience inflation of this level. BRT Co uses a nominal after-tax cost of capital of 12% to
appraise new investment projects.
Required

Assuming that production only lasts for four years, calculate the net present value of investing in the new product
using a nominal terms approach and advise on its financial acceptability (work to the nearest $1,000). (15 marks)

44 Umunat Co (FMC, 12/04, amended)

18 mins

Umunat Co is considering investing $50,000 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 20,000 units will be sold each year at a selling price
of $3.00 per unit. Variable production costs are expected to be $1.65 per unit, while incremental fixed costs, mainly
the wages of a maintenance engineer, are expected to be $10,000 per year. Umunat Co uses a discount rate of 12%
for investment appraisal purposes and expects investment projects to recover their initial investment within two
years.
Required

(a)
(b)

Explain why risk and uncertainty should be considered in the investment appraisal process.
Calculate and comment on the payback period of the project

(5 marks)
(5 marks)

(Total = 10 marks)

45 Tanumu Co (FMC, 12/04, amended)

27 mins

Tanumu Co is considering investing $50,000 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 20,000 units will be sold each year at a selling price
of $3.00 per unit. Variable production costs are expected to be $1.65 per unit, while incremental fixed costs, mainly
the wages of a maintenance engineer, are expected to be $10,000 per year. Tanumu Co uses a discount rate of 12%
for investment appraisal purposes and expects investment projects to recover their initial investment within two
years.
Required

(a)

Evaluate the sensitivity of the project's net present value to a change in the following project variables:
(i)
(ii)
(iii)

sales volume;
sales price;
variable cost;
(10 marks)

and discuss the use of sensitivity analysis as a way of evaluating project risk.
(b)

Upon further investigation it is found that there is a significant chance that the expected sales volume of
20,000 units per year will not be achieved. The sales manager of Umunat Co suggests that sales volumes
could depend on expected economic states that could be assigned the following probabilities:
Economic state
Probability
Annual sales volume (units)

Poor
0.3
17,500

Normal
0.6
20,000

Calculate and comment on the expected net present value of the project.

Good
0.1
22,500
(5 marks)
(Total = 15 marks)

Questions

37

46 Duo Co (12/07, amended)

27 mins

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 (kg)

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 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)

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).
(12 marks)

(b)

The NPV of buying the new machine is ($16,000) at a cost of capital of 15%.
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).
(3 marks)
(Total = 15 marks)

47 SC Co (6/08, amended)

27 mins

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 tax
allowable depreciation on machinery, 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.

38

Questions