BUS 5020A: Survey of Finance

Individual Assignment Two; Spring, 2021

Capital Budgeting Under Conditions of Certainty.

Instructions:

1. Answer all the questions. Deadline for submission of the assignment is Tuesday, 9th
March, 2021 at 6:00 p.m. No late submissions will be accepted.
2. Upload your solutions to Blackboard in the link under “Assignment Two” in MS-Word.
3. Your work/solutions MUST be typed in Times Roman Font 11. Avoid un-necessary
formatting.

Question One.

Gateway Construction Company, a home-building company, plans to build 200 homes over the next four
years. The purchase cost of the development site is KES 600 million, payable at the start of the first year
of construction. The company will build two types of homes, with annual sales of each home expected to
be as follows:

Year 1 2 3 4
No. of small homes sold 30 40 30 10
No. of large homes sold 14 16 30 30

Homes are built in the year of sale. Each customer finances the purchase of a home by taking out a long-
term mortgage with a participating mortgage company. Financial information relating to each type of
home is as follows:

Small house Large house

Selling price 15,000,000 26,500,000
Variable cost of construction 7,500,000 15,000,000

Selling prices and variable cost of construction are in current price terms, before allowing for selling price
inflation of 3% p.a. and variable cost of construction inflation of 5% .a.
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Fixed infrastructure costs of KES 225 million p.a. in current price terms would be incurred. These would
not relate to any specific house, but would be for the provision of new roads, gardens, drainage and
utilities. Infrastructure cost inflation is expected to be 2% p.a.

Gateway Construction Company pays profit tax one year in arrears at an annual rate of 30%. The
company can claim depreciation tax allowances on the purchase cost of the development site on a straight
line basis over the four years of construction with no terminal value expected.

Gateway Construction Company uses a cost of capital of 12% to appraise new construction projects. New
investments are required by the company to have a before-tax return on capital employed (accounting rate
of return) on an average investment basis of 25% per year.

Required:

a) Calculate the Net Cash Flows for the investment proposal. (6 Marks)
b) Calculate the NPV of the proposed investment project and discuss its financial acceptability.
(5 marks)
c) Calculate the before-tax ROCE (accounting rate of return) of the proposed investment on an average
investment basis and discuss its financial acceptability. (3 marks)
d) Discuss the effect of an unexpected huge increase in interest rates on the financing cost of Gateway
Construction Company and its clients, and on the project appraisal decision-making process of
Gateway Construction Company. (6 marks)
(20 marks)
Question Two:

Butler Pharmaceutical Company has developed a new drug that can be sold for KES 340 per unit. The
company has undertaken market research at a cost of KES 102 million in order to forecast the future cash
flows of the investment project. The drug is expected to continue gaining popularity for many years. The
Chief Finance Officer has, however, proposed that investment in the new drug 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) are as follows:

Sales volume (units) less than 1 million 1 to 1.5 million 1.6 to 2.5 million 2.6 to 3.5 million
Variable cost (KES per unit) 250 270 280 300
Total fixed costs (KES) 5 million 5.8 million 6.8 million 7.8 million

The forecasted sales volumes are as follows:

Year 1 2 3 4
Demand (units) 700,000 1,200,000 1,600,000 2,200,000

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The machinery required for production of the new drug line would cost KES 200 million. An additional
initial investment of KES 125 million will be needed for working capital. Butler Pharmaceutical
Company pays corporate tax at the rate of 30% per year, payable one year in arrears.

Selling price and cost information are in current price terms, before applying selling price inflation of
6% per year, variable cost inflation of 4 % per year and fixed cost inflation of 6% per year. Butler
Pharmaceutical Company uses a discount rate of 16% to appraise all new capital projects.

Required:

a) Assume that production lasts for only the four years under consideration above, calculate the NPV of
investing in the new machine and advice if it’s financially acceptable. (10 marks)
b) Discuss FIVE ways of incorporating risk into the investment appraisal process. (10 marks)
(20 marks)