Level 400 Management Accounting

Tutorial Question on Capital Budgeting and Investment Appraisal

Question 1

Farmers Alliance is evaluating an investment proposal to manufacture product DD3 which

requires an investment in new machinery. It has performed well in test marketing trials
conducted recently by the company’s R&D department which costs the company GH₵500,000.
The management Accountant accounted for the R&D cost as part of the initial investment in
machinery. The Management Accountant has prepared the following information relating to the
investment proposal:
Initial investment in machinery GH₵9 million
Selling price (current price terms) GH₵40 per unit
Expected selling price inflation 3% per year
Variable operating costs (current price terms GH₵16 per unit
Fixed operating costs (current price terms) GH₵340,000 per year
Expected operating cost inflation 4% per year

The R&D department has prepared the following demand forecast as a result of its test marketing
trials. The forecast reflects expected technological change and its effect on the anticipated life
cycles of product DD3.
Year 1 2 3 4
Demand(units) 120,000 140,000 240,000 90,000

It is expected that all units of product DD3 produced will be sold, in line with the company’s
policy of keeping no inventory of finished goods. The expected machinery terminal value or
machinery scrap value at the end of four years, when production of productDD3 is planned to
end is GH₵2,000,000. The machine attracts 30% capital allowance on reducing balance method.
Farmers Alliance uses a nominal (money) discount rate of 15% per year and a target return on
capital employed of 25% per year. Corporation tax is 25% and paid in the same year as related
profit. The target payback period is 3 years for the company.
Required:
(a) Identify and briefly explain the key stages in the capital investment decision making process.
(3 marks)
(b) Evaluate the proposal using the following techniques:
(i) Net present value (10 marks)
(ii) Internal rate of return (4 marks)
(iii) Discounted payback period (2 marks)
(iv) Accounting rate of return (2 marks)
(c) Discuss your findings in each section of (b) above and advise whether the investment
proposal is financially viable. (4
marks)
Question 2

Givers Industries Ltd is a listed resident manufacturing company under the government of
Ghana’s flagship programme, 1D1F. The company manufactures a special product, the ULTRA
5D SCREEN, a major input for manufacturers of television sets across the continent. The
ULTRA 5D Screen is more technically advanced than the currently available screens on the
market, which are mainly 3D. The ULTRA 5D SCREEN will require substantial investment in
plant and machinery. The initial investment in the machinery used to manufacture the ULTRA
5D SCREEN is expected to cost GHS9,000,000. Before purchasing the machinery, Givers Ltd
incurred a cost of trial and testing on the viability of the machinery, equivalent to 1/18th of the
cost. The trial and testing cost is factored into the initial investment cost. Givers will be required
to invest in working capital immediately at the cost of GHS1,250,000. The cost of setting up the
machinery to make it usable is estimated at GHS 250,000. No terminal or machinery scrap value
is expected at the end of four years when the ULTRA 5D SCREEN production is planned to end.
The machinery used in manufacturing the ULTRA 5D SCREEN is a class two (2) depreciable
asset. Capital allowance is computed per the Income Tax Act, 2015 (Act 896).

Sales in the first year are expected to be 125,000 screens. Sales are expected to rise by 20% and
15% in years 2 and 3, and dip by 20% in year 4 due to potential competition from Chinese
manufacturers. The expected selling price for the first year of production is GHS50 per unit.
Subsequent yearly selling price increases with the annual rate of inflation. Due to increased
competition, management intends to maintain stable prices for the last two years of the project.
The variable cost per unit of ULTRA 5D SCREEN is expected to be GHS25 for the first year
and increase by the inflation rate for the rest of the product’s life. Selling and administrative
expense comprise a base cost of GHS10,000 and a unit cost of GHS15 in year one, expected to
increase in line with the growth is sales units. Annual fixed operating expenses are expected to
be GHS250,000 in the first year. Further increases in fixed expenses are anticipated to be in line
with the annual inflation rates. The company is expected to pay a one-time insurance cost of
GHS125,000 in year three after adjusting for the effect of inflation. The rate of inflation, as
projected by the Statistical Service, is expected to be 6% for the first two years and 8% for years
3 and 4. The target payback and discounted payback periods are 3 and 5 years, respectively, for
projects of this kind. The company pays income tax at the rate of 30%. Givers Industries uses a
nominal discount rate of 20% for all of its capital projects.

You are required to:

a. Using (a), evaluate the proposal and advise whether the investment is financially viable using
the following techniques:
i. Net present value [15 marks]
ii. Payback and Discounted payback period [4 marks]
Question 3

Pearly Company Ltd is a listed resident manufacturing company under the government of
Ghana’s flagship programme, 1D1F. The company manufactures a special product, the ULTRA
5D SCREEN, a major input for manufacturers of television sets across the continent. The
ULTRA 5D Screen is more technically advanced than the currently available screens on the
market, which are mainly 3D. The ULTRA 5D SCREEN will require substantial investment in
plant and machinery. The initial investment in the machinery used to manufacture the ULTRA
5D SCREEN is expected to cost GHS9,000,000. Before purchasing the machinery, Pearly
Company Ltd incurred a cost of trial and testing on the viability of the machinery, equivalent to
1/18th of the cost.

Initial investment in machinery GH₵9 million

Selling price (current price terms) GH₵50 per unit

Variable operating costs (current price terms GH₵25 per unit

Fixed operating costs (current price terms) GH₵250,000 per year

The trial and testing cost is factored into the initial investment cost. Pearly will be required to
invest in working capital immediately at the cost of GHS1,250,000.

Subsequent yearly selling price increases with the annual rate of inflation. Due to increased
competition, management intends to maintain stable prices for the last two years of the project.
The variable cost per unit of ULTRA 5D SCREEN is expected to increase by the inflation rate
for the rest of the product’s life. Selling and administrative expense comprise a base cost of
GHS10,000 and a unit cost of GHS15 in year one, expected to increase in line with the growth in
sales units. The company is expected to pay a one-time insurance cost of GHS125,000 in year
three after adjusting for the effect of inflation.
The rate of inflation, as projected by the Statistical Service, is expected to be 6% for the first two
years and 8% for years 3 and 4. The cost of setting up the machinery to make it usable is
estimated at GHS 250,000. No terminal or machinery scrap value is expected at the end of four
years when the ULTRA 5D SCREEN production is planned to end. The machinery used in
manufacturing the ULTRA 5D SCREEN is a class two (2) depreciable asset. Capital allowance
is computed at the rate of 30%.

The R&D department has prepared the following demand forecast as a result of its test marketing
trials. The forecast reflects expected technological change and its effect on the anticipated life
cycles of product ULTRA 5D SCREEN.

Year 1 2 3 4

Demand(units) 125,000 150,000 172,500 138,000

The target payback and discounted payback periods are 3 and 5 years, respectively, for projects
of this kind. %. Givers Industries uses a nominal discount rate of 20% for all of its capital
projects.

b. Using (a), evaluate the proposal and advise whether the investment is financially viable using
the following techniques:
i. Net present value [16 marks]
ii. Payback period and Discounted Payback [4 marks]