CAPITAL BUDGETING UNDER CERTAINTY
- Explain why capital budgeting decisions are important.
- c) (i) Why capital budgeting decisions are important
The long-term investment decision is called capital budgeting. It is important because of the following reasons:
- Capital budgeting decisions involve investment in long-term fixed assets and therefore affect long-term growth.
- Capital budgeting involves a huge amount of funds for a long period. Thus, the capital budgeting decision should be taken rationally.
- Capital budgeting decisions affect the returns of a firm as a whole. Therefore, it involves a lot of risk.
- Capital budgeting decisions, once taken, cannot be reversed without involving heavy losses.
- Bidii Ltd. is considering investing in a plant which is expected to operate for the next four years after which it will have no salvage value. The plant will cost Sh.5 million. Annual tax depreciation of 25% will be allowed in respect of the expenditure.
Revenue from the plant will be Sh.7 million per annum for the first two years and Sh.5 million per annum thereafter. Incremental costs will be Sh.4 million throughout. Bidii Ltd. pays corporation tax at 30% and has a cost of capital of 10%. Assume that all cash flows occur at the end of the year to which they relate.
Advise Bidii Ltd. on whether to proceed with the investment.
December 2014 Question Two C
- Explain four features of an ideal investment appraisal method.
- a) Features of an ideal investment appraisal method:
- It should use all the cash flows of the project in evaluating the project.
- It should consider the time value of money by discounting the expected future cash flows of the project.
- It should be consistent with the goal of shareholders wealth maximisation.
- It should distinguish between two or more mutually exclusive projects and should rank them in order of their economic viability.
- It should distinguish between accepted and unacceptable projects (it should have a decision criteria).
- It should be applicable to any conceivable project independent of all other projects.
- Kiwanda Ltd. is considering the launch of a new product “M” for which an investment of Sh.6 million in plant and machinery will be required. The production of “M” is expected to last for five years after which the plant and machinery would be sold for Sh.1.5 million.
- “M” would be sold at Sh.600 per unit with a variable cost of Sh.240 per unit.
- Fixed production costs (excluding depreciation) would amount to Sh.600,000 per annum.
- The company applies the straight line method of depreciation.
- The cost of capital is 10% per annum.
- The number of units of “M” expected to be produced and sold per annum for the next five years is shown below:
|Units expected to be produced and sold
- The corporation tax rate is 30%.
Advise the management of Kiwanda Ltd. on the appropriate course of action using:
- The net present value (NPV) approach.
- The internal rate of return (IRR) approach.
May 2014 Question One
- a) Bram Ltd. has found out that, after two years of using a machine, a more advanced model has arrived in the market. The advanced model is expected to increase output. The existing machine had cost sh. 32,000 and was being depreciated using the straight – line method over ten years. The current market value of the existing machine is sh. 15,000.
Bram Ltd. is considering the acquisition of the advanced model which costs sh. 123,500 including installation costs and has a salvage value of sh. 20,500 at the end of 8 years of its useful life. The following data has been provided:
|Advanced model machine
|Capacity per annum
Selling price per unit:
Production cost per unit:
Fixed overheads (allocated)
The required rate of return is 15%. Ignore taxation.
Compute the following in respect of the new machine:
- Payback period.
- Net present Value (NPV). iii. Internal rate of return (IRR).
June 2013 Question Four A
(a) Bright Ltd. undertook project X with the following cash flow over its useful life of 3 years. The cost of capital for the project is 10%. The abandonment values of the project have been given below:
|Cash flow (Sh. “000”)
|Abandonment values (Sh.“000”)
Advise the management of Bright Ltd. when to abandon project X.
December 2012 Question Three B
- b) ABC Ltd. has the following proposed independent projects for the year ending 31 December 2012:
|Net investment outlay
|Present value of future net cash flow
- Assuming that there is no capital rationing, indicate which projects should be selected.
- Total net present value (NPV) of the selected projects.
- Assuming a single period internal capital constraint of Sh. 1,700,000 is imposed, indicate which projects should be selected.
May 2012 Question Four B
- d) Tezo Ltd. is in the process of modernising its operations. The factory manager has proposed the replacement of the milling machine with a new fully computerised machine. The milling machine was purchased two years ago at a cost of Sh.4 million. The economic life of the machine was five years. However, a management review has established that the machine has a further useful life of five years with a zero salvage value. The machine could be disposed of immediately at Sh. 1.6 million.
The new machine has a purchase price of Sh.8 million with an additional installation cost of Sh. 1.8 million and a salvage value of Sh.2 million. The new machine will lead to increased efficiency and annual savings in costs of Sh.2.1 million. However, electricity costs will increase by Sh.200, 000 per annum. The operation of the new machine will also require an increase of Sh.810, 000 worth of raw materials. The company uses the straight line method of depreciation. The company’s cost of capital is 10% and the corporate tax rate is 30%.
Advise the management of Tezo Ltd. on whether to replace the machine.
May 2012 Question Three D
- b) Dzitsoni Ltd. is considering replacing a machine. The existing machine was bought 3 year ago at a cost of Sh 50 million. The machine is expected to have a useful life of 5 more years with no scrap value at the end. The machine could be disposed of immediately at Sh.35 million. The new machine will cost Sh. 80 Million with a useful life of 5 years and an expected terminal value of Sh.5 million. With the introduction of the new machine sales are expected to increase by Sh.25 million per annum over the next five years.
The contribution margin is expected to be 40% and the corporate tax rate is 30%. The operation of the new machine will also require an immediate investment of Sh.8 million in working capital. Installation costs of the new machine will amount to Sh 6 million. Depreciation is to be provided for on a straight line basis. The company’s cost of capital is 12%. Capital gain taxes remain suspended and not applicable.
- The initial investment for the replacement decision.
- Advise the management of Dzitsoni Ltd. on whether to replace the machine.
November 2011 Question Three B
- Outline four factors that could influence the capital structure of a company.
- a) Four factors that could influence the capital structure of a company
- Management towards risk-
If the management is risk averse they may tend to use equity capital than debt capital.
- The cost of capital-
The cost of each and every source of capital i.e. cost of debenture, preference share capital and equity capital will influence the capital structure.
- The rates of tax-
Firms operating in countries where there are high tax rates they use more of debt capital in order so as to enjoy the tax advantages.
- Ability of the firms earnings to support the capital structure-
The earnings of the firm should be considered and assess whether they are able to support the capital structure.
- Differentiate between the term “weighted average cost of capital” and “marginal cost of capital”.
- Difference between weighted average cost of capital and marginal cost of capital
- Weighted average cost of capital-
This is the overall cost of capital on funds utilized. It is the cost of funds already raised by the firm to finance its existing projects. It’s based on the weights or proportions of capitals contributed in the capital structure.
Marginal cost of capital-
This is the cost of incremental or additional new capital. It’s the cost of raising new capital to finance new projects. It should be the relevant investment discounting rate for capital budgeting purposes because in the capital budgeting process, the firm is concerned with selection of new projects.
- Lang Ltd is interested in measuring its overall cost of capital and has gathered the following data for the year 2011:
Debt The firm can raise an unlimited amount of debt by selling Sh. 1,000 per value 8% coupon rate, 20 year bonds on which annual interest payments will be made. To sell the issue, an average discount of Sh. 30 per bond would be given
Preference stock The firm can sell 8% preferred stock at its Sh. 95 share per value. The cost of issuing and selling the stock is expected to be Sh. 5 per share. An unlimited
amount of preferred stock can be sold under these terms.
|The firm can raise all unlimited amount of debt by selling Sh. 1,000 per value 8% coupon rate, 20 year bonds on which annual interest payments will be made. To sell the issue, an average discount of Sh. 30 per bond would be given
|The firm expects to have Sh. 100,000 of retained earnings in the coming year 2012. New shares can be issued at Sh 62 each with a flotation cost of Sh 2 per share. The growth rate is expected to be 6%. Expected dividend in the coming year is Sh. 6.
The company’s estimate optimal capital structure is given below.
Sh. “000” Debt 30,000
Preferred stock 20,000
The company tax is at 30%
- Compute the specific cost of each source of financing
- Determine the breakpoint and the weighted average marginal cost of capital below the breakpoint.
November 2011 Question One
- Briefly describe the mean-variance rule.
- Three options are available to the investment manager of Maendeleo Ltd. as follows:
− Project Weka may yield a return of Sh.20 million with a probability of 0.3, or a return of Sh.40 million with a probability of 0.7.
− Project Leta may earn a return of Sh.20 million with a probability of 0.3 or a return of Sh.55 million with a probability of 0.7
− Project Pato yields a return of Sh.30 million with a probability of 0.5 or Sh.40 million with a probability of 0.5
By applying the mean-variance rule, advise Maendeleo Ltd investment manager on the best investment option.
The best investment option is project Pato since it provides greatest return per unit of risk.
June 2011 Question One A and B
June 2011 Question One A and B
- c) Pwani Dock Limited is considering reopening of one of its loading docks. New equipment will cost sh. 50,000,000payable immediately. To operate the new dock will require additional dockside employees costing sh. 16,000,000 per annum. There will also be need for additional administrative staff and other overheads such as extra stationery, insurance and telephone costs amounting to sh. 19,000,000 per annum. Electricity used on the dock is anticipated to cost sh. 10,000,000 per annum.
The head office will allocate sh. 10,000,000 of its (unchanged) costs to this project. Other docks will experience in receipts of about sh.6, 000,000 due to some degree of cannibalization. Annual fees expected from the new dock are sh. 60,000,000 per annum.
- All cash flows arise at the year-end except the initial equipment acquisition costs which are incurred at the outset.
- There are no taxes levied or inflation experienced.
- There are no services provided on credit.
- Show the net annual cash flow calculations and explain the reasons for the calculations.
- Assuming an infinite life for the project and a cost of capital of 17 per cent, calculate the net present value (NPV) of the project.
June 2011 Question Two C
- b) Mavoko Ltd. manufactures a component known as “Fixit” which is used in the manufacture of locally assembled desktop computers. While the current production capacity is one million units of “Fixit”, demand for the component is expected to be as follows:
The company is planning to acquire an additional machine at a cost of sh. 8,000,000 which will have a useful life of 4 years and a maximum output of 600,000 units. The scrap value of the machine after four years will be sh. 300,000.
The current selling price of “Fixt” is sh. 80 per unit and the variable cost is sh. 50 per unit. Other variable costs of production are sh. 19. Fixed costs of production associated with the new machine would be sh. 2,400,000 in the first year of production increasing by sh. 200,000 per year in each subsequent year of operation.
Mavoko Ltd. pays tax one year in arrears at an annual rate of 30% and can claim capital allowance on a 25% reducing balance basis. A balancing allowance is claimed in the final year of operation.
The cost of equity for mavoko Ltd. is 10% while it pays an interest of 8.6% on its debts. Its long term fiancé is made up 80% equity and 20% debt.
- i) Calculate the net present value (NPV) of buying the new machine. ii) Calculate the internal rate of return (IRR) of the new machine.
iii) Advise the management of Mavoko Ltd. on whether to buy the new machine.
December 2010 Question Three B
Omega Manufacturers ltd is contemplating investing in a machine for its manufacturing processes. The machine will be used to manufacture a product known as “omega”. The machine will cost sh.5 million and will incur installation costs amounting to sh.500,000.The machine is expected to have an economic useful life of 5 years and a resale value of sh.1 million at the end of this period.
The acquisition of this machine is expected to cause changes in working capital at the beginning of the expected life of the machine. Inventory balances are expected to increase by sh.2 million ,accounts receivable will increase bysh.2.5,accounts payable will increase by sh.1.5,accrued expenses and prepaid expenses are expected to decrease by sh.0.5 million and sh 0.4 million respectively. The net change in working capital will be recovered at the end of the machine’s economic life.
The quantity of ‘omega” expected to be manufactured and sold in each year will be as follows:
Quantity manufactured and sold
- Each unit of omega is expected to be sold at sh.100 in year 1.However the price is expected to increase by 10% annually thereafter.
- The variable cost per unit for omega is estimated at Sh.20 in year 1.In subsequent years, this cost will rise at the same rate as the increase in the selling price.
- Fixed costs per annum excluding depreciation are estimated at sh.0.5 million.
- The company applies the straight line method of depreciation for all its fixed assets.
- The company’s cost of capital is 12%
- Corporation tax rate is 30%.Corporation tax is paid one year in arrears.
Using the net present value (NPV) technique, advise the company on whether the machine should be purchased.
June 2010 Question One
High Tec Electronics Ltd is considering the acquisition a new machine to replace existing machine currently being used in the production of product “Q”.
The existing machine was acquired 5 years\ ago at a cost of Sh.40; 000,000.The machine was originally estimated to have a useful life of 10 years with a nil salvage value at the end of its useful life. However, following a revaluation of the machine, it is now estimated that the machine can be used for another 15 years with a salvage value of sh.5,000,000.The current disposal value of the machine is sh.30,000,000.
The new machine is estimated to cost sh.100, 000,000.The Company will incur an installation cost of sh.20, 000, 000.However, the machine will require an overhaul at the end of 10 years.
The overhaul will involve the acquisition of new parts and will cost sh.20; 000,000.The new machine is expected to have a useful life of 15 years and a salvage value of sh.30, 000,000 at the end of its useful life. Investing in the new machine will also require an additional investment in working capital of sh.40, 000,000 at the end of 5 years. The investment in working capital will however be recovered at the end of the machine’s useful life.
The following information relates to the new machine and the existing machine’s expected output of product “Q” over the 15 years period.
- The unit selling price and unit variable cost of product “Q” are sh.25 and sh.15 respectively. These are expected to remain constant over the 15 years period.
- The annual fixed costs excluding depreciation associated with the new machine are expected to increase by sh.100,000,000 over the 15 years period.
- The company applies a policy of straight line depreciation for all its fixed assets.
- The overhaul cost of the new machine will be amortized separately over the remaining useful life of the machine on straight line basis.
- The company’s cost of capital is 20%.
- Corporation tax rate is 30%.
Assume all cash flows, unless otherwise stated occur the end of each year.
Using the net present value (NPV) technique, advice the company on whether it should replace the existing machine with the new machine.
December 2009 Question One
- Briefly explain three types of real options available in capital investments decisions.
- a) Types of real options available in capital investment decisions
- The option to vary output
If the condition turns favorable production can be expanded. Production can also be contracted if condition turns unfavorable
- The option to abandon
If the project has abandonment value this effectively represents an option to the project own. iii. The option to postpone. Also known as an investment timing options. For some projects ,
there is the option to wait thereby obtaining new
- Other options
Option to change production process or technology
- Option to vary the mix of output in response to market demand
- Widespread investment company Ltd. is planning to develop and market product “X”. Annual cash flows associated with the project are as follows:
The company will have the option to invest an additional sh. 1 billion at the end of the year 5 to secure a national market. Annual net cash flow are expected to be sh. 600 million higher in each of the years 6 to 10.
The company’s required return is 12%.
Assume the project is successful and all cash flows occur at the end of each year.
- Basic net present value (NPV) of the project without real options.
- Net present value (NPV) of the project with real option.
- What are your recommendations based on (i) and (ii) above?iii. Recommendations The basic project without the real option is not viable since it has negative NPV. The option value has raised the work of the project and the project with real option is viable since it has a positive NPVAugust 2009 Question One
August 2009 Question One.
- c) Aruna Ltd. is evaluating an investment project which requires the importation of a new machine at a cost of sh. 2,700,000. The machine has a useful life of six years.
- The following additional costs would be incurred in relation in to the machine.
|Installation and preproduction testing
- The machine is expected to increase the company’s annual cash flows (before tax) as shown below.
|Increase in cash flow(sh.)
- The machine is to be fully depreciated over its useful life using the straight line method.
- The corporate rate tax is 30% while the cost of capital is 12%.
- The maximum acceptable payback period to the company for all capital projects is four years.
- Payback period of the machine.
- Met present value (NPV) of the machine.
- Advise the company on whether to import the machine based on your results in (c)(i) and (ii) above.
December 2008 Question One C