TUTORIAL 5 – Capital Investment Decisions

Week 7

Question 1

Amjad wants to buy a new piece of equipment and there are two different models that
he can choose from; one is slightly more reliable and efficient than the other, and both
have a useful economic life of 5 years. The information for each of the potential
investments is as follows:

Equipment A Equipment B
Initial investment cost £100,000 £175,000
Profit* Year 1 £50,000 £50,000
Profit* Year 2 £50,000 £50,000
Profit* Year 3 £30,000 £60,000
Profit* Year 4 £20,000 £60,000
Profit* Year 5 £10,000 £60,000
Disposal value of equipment £20,000 £25,000

* Profit is calculated before deducting depreciation.

Calculate the Accounting Rate of Return. Determine which item of equipment should
be purchased if Amjad’s normal target ARR is 25%. Assume the business uses
straight line depreciation.

Question 2

Camden plc is considering buying some equipment to produce a chemical named

X14. The new equipment’s capital cost is estimated at £100,000. If its purchase is
approved now, the equipment can be bought and production can commence by the
end of this year. £50,000 has already been spent on research and development work.
Estimates of revenues and costs arising from the operation of the new equipment
appear below.

Year 1 Year 2 Year 3 Year 4 Year 5

Sales Price (£/litre) 100 120 120 100 80
Sales Volume (litres) 800 1,000 1,200 1,000 800
Variable cost (£/litre) 50 50 40 30 40
Fixed cost (£000) 30 30 30 30 30

1
If the equipment is bought, sales of some existing products will be lost, and this will
result in a loss of contribution of £15,000 a year over its life.
The accountant has informed you that the fixed cost includes depreciation of £20,000
a year on the new equipment. It also includes an allocation of £10,000 for fixed
overheads. A separate study has indicated that if new equipment were bought,
additional overheads, excluding depreciation, arising from producing the chemical
would be £8,000 a year. Production would require additional working capital of
£30,000.

Required:
(a) Deduce the relevant annual cash flows associated with buying the equipment.
(b) Deduce the payback period.
(c) Calculate the net present value using a discount rate of 8 per cent

Question 3

Compare and contrast the accounting rate of return method and the payback period
method.

(Note: no model answer is provided for question 3 – it will be based on the class
discussion during the tutorial and the lecture and textbook materials)

Question 4 (to be completed as self-study after the tutorial)

A hospital is considering purchasing a new X-ray machine, as part of a larger

initiative to improve the productivity of its X-ray department. After carefully
searching through various X-ray models, the hospital has narrowed its search down to
a new X-ray model, the SUPREME X-ray machine.

The hospital generates £200,000 annual revenue from its X-ray department. This
revenue is based on a fixed-rate charged per diagnosis and doesn’t depend on the
number of X-rays taken. Therefore, the department’s revenue is not expected to
change if the new X-ray machine is purchased. The SUPREME is faster and easier to
operate than the existing X-ray machine and also has the ability to X-ray larger areas.
As a result, if the SUPREME is purchased labour costs are expected to decrease by
£40,000 per year and fewer X-rays will be required, on average, per patient reducing
operating costs by £25,000 every year.

2
The existing X-ray machine can operate for another 4 years and will have a disposal
value of £5,000 at the end of the four years. If the existing X-ray machine is sold
today, the hospital estimates that it can get £45,000 from its sale. The hospital
manager expects the SUPREME X-ray machine to have a useful life of 4 years, at
which point it can be disposed of for £60,000. The SUPREME can be currently
purchased for £300,000. If the SUPREME is purchased, the hospital will have to
make an additional investment in working capital (i.e. in supplies and spare parts for
the new machine) of £15,000. The hospital uses a cost of capital rate of 10%.

Required:
(a) Determine the relevant annual cash flows arising from the hospital’s decision
to purchase the SUPREME X-ray machine, as opposed to operating using the
existing X-ray machine.
(b) Calculate the Net Present Value of purchasing the SUPREME, as opposed to
staying with the existing machine.
(c) What other factors might the hospital management consider prior to making its
final decision on whether or not to purchase the SUPREME X-ray machine?