LANDMARK UNIVERSITY

COLLEGE OF BUSINESS AND SOCIAL SCIENCES

Department of Finance

BFN 411: FINANCIAL MANAGEMENT

CAPITAL INVESTMENT ANALYSIS WITH TAXATION AND REPLACEMENT
DECISION

Illustration 1
Landmark Ventures is considering investing in equipment, it has received a proposal of N6m
for it and the expected gross savings before depreciation and taxes are as follows;
Nm
Year 1 2m
Year 2 1.8
Year 3 1.6
Year 4 1.4
Year 5 1.4
The equipment will have to be to be overhaul at the end of the 3rd year at an estimated cost of
N600, 000. Assume the equipment can be sold up at N1m at the end of the period and a tax
rate of 40% is applied in the same year that the cashflow are generated, advise the directors
whether to invest in the project or not. (The company’s rate of return is assume to be 20%
and a straight line method of depreciation is applied.

Solution
Landmark Ventures

Workings
Year 1 2 3 4 5
N'000 N'000 N'000 N'000 N'000
Gross savings 2 1.8 1.6 1.4 1.4
Overhaul - - -0.6 - -
Cashflow 2 1.8 1 1.4 1.4
Depreciation (1.0) (1.0) (1.0) (1.0) (1.0)
1 0.8 0.0 0.4 0.4
Scrapvalue - - - - 1
Net Income 1.0 0.8 0.0 0.4 1.4
Tax @ 40% 0.4 0.32 0 0.16 0.56
0.4 0.60 0.48 0.00 0.24 0.84
Add back dep. 1 1 1 1 1
1.60 1.48 1.00 1.24 1.84

Cashflow DCF@20
Year (N'm) % PV
0 (6.000) 1.000 (6.000)
1 1.600 0.8333 1.333
 2 1.480 0.6944 1.028
3 1.000 0.5787 0.579
4 1.240 0.4823 0.598
5 1.840 0.4018 0.739
(1.723)

The directors should not accept the project because it has a negative NPV

Illustration 2
The finance team of Laspalm plc has been asked to assess two mutually exclusive projects.
Project A requires an initial capital outlay of N100,000 and has a two year life with projected
profit outcomes of N60,000 per annum. This project profit includes;
 Fixed overheads amounting N10,000 per year, N6,000 of which are derived from the
process of allocating general head office to specific jobs. The remaining N4,000 are
additional overheads expected to be incurred due to undertaking the project.
 Labour cost of N15,000 per annum relating to the specific employees that would be
allocated to this project. These employees are currently schedule to be working
elsewhere in the organization. If they are moved then additional part time staff would be
employed on short term contracts at N12,000 per annum to complete the other work.
 Development costs of N14,000 in year 1 and N8,000 in year 2. This include N8,000
each year for amortization of capitalized development costs specifically relating to this
project and already incurred. The remaining N6,000 in year 1 is due to further
development costs (relating to an intermediate installation) that are expected to be a
necessary expense during the first year.

Project B has a life of 4 years and requires N400,000 capital outlay which is expected to
generate future annual net cashflows of N148,000.

There is some dispute within the finance team as to the most appropriate approach to the
appraisal. One member of staff has proposed that the appraisal advise should be based upon
an internal rate of return evaluation and another member of staff has suggested that Net
Present Value should be the decision criterion, using the Laspalm plc cost of capital of 14%.

Required
1. Evaluate the projects using each of the proposed methods.
 2. Using your results from (1) advice Laspalm plc on the investment strategy relating to
these projects.
Solution
Laspalm plc

Determination of
Cashflow

Initial Investment N100,000

Cash inflow Yr 1 Year 2
Annual Revenue 60,000 60,000
Fixed cost allocated 6,000 6,000
Opportunity cost in
Labour -12,000 -12,000
Developmental Cost 8,000 8,000
62,000 62,000

NPV
DCF@14
Yr Cashflow % PV
(100,000
0 (100,000) 1 )
1 62,000 0.8772 54,386
2 62,000 0.7695 47,709
NPV 2,095

Try 18%
DCF@18
Yr Cashflow % PV
(100,000
0 (100,000) 1 )
1 62,000 0.8475 52545
2 62,000 0.7182 44528.4
(2,927)

1RR
LR NPV+
NPV(+) -
NPV(-) (HR -LR)
14 2095 (4)
5022
15.67%

Project B
DCF@14
Yr Cashflow % PV
 (400,000
0 (400,000) 1 )
1-4 148,000 2.9137 431227.6
NPV 31,228

DCF@18
Yr Cashflow % PV
(400,000
0 (400,000) 1 )
1-4 148,000 2.3616 349516.8
(50,483)

IRR
14+ 31228 (11)
81,771

18.20%

-+Using NPV and IRR criteria accept

project B

Illustration 3
Victory plc is considering expanding his long established manufacturing business by
marketing an entirely new product line. The expansion would require an investment of
N50,000 in research and development and advertising costs. N 20,000 in working capital and
an expected N 182,300 on new machinery. In addition certain items of loose tools and
equipment, having a book value of N 17,000 which victory plans to sell for N 1,700 would
have to be used.
The venture is expected to generate revenue of N230,000 for four years at an annual cost of
N150,000. At the end of the four years, 50% of the working capital could be recovered and
the fixed assets sold for N44,000. It is thought that the realizable value of the fixed assets
throughout the life of the project would be N120,000, N79,000 and N60,000 at the end of the
first three years.
Ignoring taxation and assuming all cash flows occur annually in arrears, calculate
a. The return on capital employed expressing average annual pre-tax earnings as a
percentage of initial capital cost.
b. The Annual Rate Return on the project
c. The payback period.
 d. The payback period incorporating a bail out factor
e. The NPV at 10%
f. The NPV at 25%
g. The IRR

REPLACEMENT DECISION

Illustration 4
A printing and binding company has yearly sales of N450,000 and administrative expenses of
N250,000. Its target annual rate of return on investment is 15%. The Managing Director
wants to replace an old printing machine with a new one of more modern design because it
will reduce operating costs (other than those of machinery maintenance) by N11,285 per
year. From N161,285 with the old machine to N150,000 with the new one. However, his print
shop manager argues against such course.
The following facts about the machine are common ground. The old machine is 8 years old
and stands in the book at N45,500 having cost N93, 500 when new and having been
depreciated at a rate of N6,000 per year. At the present time the old machine could be
disposed off for N11,500 less N1,000 removal cost. While its value at the end of its useful
life 7 years from now is estimated to have a value of N3,500. The new machine which will
cost N44,000 will last 7 years from now is estimated to have a value of N3,750 at the end of
that period. Its effect on annual maintenance costs will be to increase them by N2,000 in each
of the first years of its acquisition and to reduce them by N500 in each of the remaining
years.

The print shop manager contends that there is nothing to be gained through the change and
produce the following schedule:
Cost of new Investment:
N
Outlay on purchase and maintenance 45,500
Loss on old machine N45, 500 – N10,500 35,000
Total cost 80,500
Savings N11,285 x 7 78,995
Gain(Loss) on Investment (1,505)

He goes on to say that he can never see the point of disposing of fixed assets at a loss before
their useful life expires.

You are required to:

a. Prepare a computation showing the new benefit or cost at the target rate of return if
the old machine is scrapped and the new machine purchased.
b. As a Net Present Value, in the form of seven-year annuity representing a constant
annual amount.
c. Comment upon the part played by the following factors in a decision of this kind.
 Book value of old equipment
 Disposal value of old equipment
 Gain or loss on disposal
  Cost of New equipment
d. Criticize briefly the print shop manager’s schedule and his views
e. Payback period.

Solution
Determination of relevant cash flow
Savings on operating cost = N11,285 per year
Old Machine
Cost price N93,500
Depreciation (6000 x 8yrs) N48,000
Book value after 8 years N45,500 Irrelevant
Scrap value N11,500 – N1,000 = N10,500 inflow
Scrap value in 7 years time N3,500 outflow

New Machine N
Cost of New machine 44,000 outflow
Scrap value in 7 yrs time 3,750 inflow
Increase Maintenance cost 1st 2yrs 2,000 outflow
Savings on Maintenance cost 3-7yrs 500 inflow

a. Computation of Cost Benefit If New Machine is Acquired

Description Yrs. Cashflow DCF@15% PV

Cost of New Machine 0 (44,000) 1 (44,000)
Scrapvalue old machine 0 10,500 1 10,500
Increase in Maintenance Cost 1-2 (2,000) 1.63 (3,260)
Savings on maintenance cost 3–7 500 2.53 1,265
Savings on operating cost 1–7 11,285 4.16 46,946
Scrap value of old machine 7 (3,500) 0.38 (1330)
Scrap value of New machine 7 3,750 0.38 1,425
11,546

b. NPV at annuity 11,546

4.16 = 2,775.48

c.
 Book value of old equipment - The book value is derived from sunk cost, the original
record is irrelevant as such any cost arising there from is equally irrelevant.

 Disposal value of old equipment - There is an element of opportunity revenue in that if

we are able to buy the new machine we will be able to dispose off the old machine to
generate N10,500 which is an inflow. Relevant

 Gain or loss on disposal – Derivation of accounting concept. Irrelevant

 Cost of New equipment- Because it involves movement of fund it is relevant.

Criticism of Print Shop Managers computation

  The schedule is a mixture of relevant and irrelevant cashflows. For instance, the
N45,500 which is the cost of the existing machine is a sunk cost and should not affect
current decision.
 The loss on the old machine calculated by the print manager is also misleading
because it involves accounting convention and should not affect decision.
 The savings is an incremental cashflow and should correctly be brought into the
analysis and so many other relevant items are left out in the analysis, some of these
are; The impact of the new machine on the maintenance cost and the scrap value of the
old and the new machine in 7 years.

Illustration 5
Distinct Places Ltd is looking into the possibility of manufacturing a new product. A total
cost of N12,000 has so far been incurred on research and development. A machine would
need to be bought at a cost of N120,000 payable in two installments, one immediately and
one in one year’s time if the machine had been operating correctly for a year. The equipment
would be depreciated on a straight line basis by N10500p.a for 10years and then sold for
N15,000.
Uses would be made of some existing equipment which originally cost N18,000 has a book
value of N3,000 would cost N27,000 to replace though the company is considering selling it
for N6,000.
Production and labour costs for the first year would amount to N165,000 payable in one
year’s time though the next nine years cost would fall to N135,000. Revenue of N174,000
would first be receivable in two year’s time and for the following nine year. The project
would require N15,000 Fixed costs per annum before the project can be executed.

The company’s after tax cost of capital is 10%.

You are required to calculate for the project:
a. i. Average annual pre-tax accounting profit on the project as a percentage of the book
value of the initial investment.
ii. The same profit as a percentage of the average book value of the investment
iii. Total accounting profit as a percentage of the initial investment.
b. The payback period
c. The NPV
d. The DCF yield