TOPIC 1
ADVANCED CAPITAL BUDGETING DECISION
QUESTION 1
August 2024 Question One B
A company is considering two mutually exclusive projects namely; project A and project B. The company uses the certainty equivalent approach to evaluate capital projects. The estimated cash flows and certainty equivalents for each project are as follows:
The risk free rate is 5%.
Required:
Advise the company on which project to undertake using the certainty equivalent method. (6 marks)
QUESTION 2
April 2024 Question One A and C
Summarise FOUR causes of hard capital rationing as used in capital budgeting.
(4 marks)
(c) Kangaro Youth Sports Ltd. wishes to design a new sports bicycle. The company will have to invest Sh.100 million at the beginning of the first year for the design and model testing of the new bicycle.
The firm’s managers believe that there is an 80% probability that this phase will be successful and the project will continue.
If Phase 1 is not successful, the project will be abandoned with zero salvage value.
The next phase, if undertaken, would consist of making the molds and producing twenty prototype bicycles. This would cost Sh.400 million at the end of the first year. If this phase is successful, the firm would go into full scale production. If the phase is not successful, the molds and prototypes could be sold for Sh.150 million. The managers estimate that the probability that the bicycles will pass the test is 90% and that Phase 3 will be undertaken.
Phase 3 consists of changing over current production line to produce the new design. This would cost Sh.1,100 million in year 2.
If the economy is strong at this point, the net value of cash flows would be Sh.3,500 million, while if the economy is weak the net value of cash inflows would be Sh.2,600 million. Both net values of cash inflows will be realised at the end of year 3 and both states of the economy are equally likely.
The company’s cost of capital is 13%.
Required:
Using a decision tree, determine the project’s expected net present value (ENPV). (5 marks)
Calculate the project’s standard deviation of expected net present value and comment on the result. (4 marks)
Using the normal probability distribution, compute the probability that the project’s net present value will be at least Sh.80 million. (3 marks)
QUESTION 3
December 2023 Question One A
The management of Kapricon Ltd. are in the process of estimating utile and establishing the categories of investors. The management has approached CPA Samuel Okeyo, a financial management consultant and provided him with the following cases:
Case 1: There is 0.50 chance of receiving Sh.30 million and 0.50 chance of receiving Sh.100 million. The investor is willing to pay a maximum of Sh.60 million.
Case 2: There is 0.40 chance of receiving Sh.55 million and 0.60 chance of receiving Sh.100 million. The investor is willing to pay a maximum of Sh.82 million.
Case 3: There is 0.30 chance of receiving Sh.30 million and 0.70 chance of receiving Sh.60 million. The investor is willing to pay a maximum of Sh.45 million.
Assume that utile values of 0 and 1 are assigned to a pair of wealth representing the two extremes Sh.0 and Sh.100 million respectively.
Required:
Using the expected monetary value (EMV) technique, determine the category of investor in case 1, case 2 and case 3 above. (6 marks)
Compute the utile value for case 1, case 2 and case 3 respectively. (3 marks)
QUESTION 4
August 2023 Question Two B
Tobin Ltd. is appraising an investment project which has a cost of Sh.20 million payable in full at the start of the first year of operation. The project life is expected to be four years. Forecast sales, volumes, selling prices, variable costs and fixed costs are as follows:
