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    5 views14 pages

    FM 5b

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    demolaojaomo

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    © All Rights Reserved
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    of 14
    Chapter $ upital Expenditure Decisions PROJECT B Yr CRN) DF @ 10% — PV(N) 0 (867,800) 1 (867,800) 1-10 200,000 6.145 1.229.000 361,200 (ii) Computation of the projects’ IRRs PROJECT A Yr CRN) DF @ 30% PV(N) 0 (1,410,400) 1 (1,410,400) 1-10 300,000 3.092 927,600 IRR= 10 x [30-10] PROJECT B Yr CF) DF @ 30% PV(N) 0 (867,800) 1 (867,800) 1-10 200,000 3.092 618.400 (249.400) IRR = 10 + _361,200 x {30-10} 610,600 IRR =_21.83% (>) Caleulations of the NPV & IRR of the incremental cash flows between project A and project B. Yr CFN) DF @ 10% PV(N) 0 (542,600) 1 1-10 100,000 6.143 financial management 94 Chapter $ Capital Expenditure Decisions Yr CFO) DF@15% — Py(Ny 0 (542,600) T (542,600) 1-10 100,000 5.019 501,91 (40.700) IRR = 10 + 71,900 x {15-10} 112,600 IRR = 13.19% ie the incremental IRR The implication of this incremental IRR is that the two projects will produce the same NPV if appraised at the rate catculated (except for rounding errors). It is the rate of indifference. (©) Calculation of the NPVs of project A & B at the alternative rate of 14% PROJECT A Yr CRN) DF@14% Pv) 0 (1,410,400) 1 (1,410,400) 1-10 300,000 5.216 1,564,800 PROJECT B Yr CFO) DF @ 14% Pv) 0 (867,800) 1 (867,800) 1-10 200,000 5.216 1,043,200 175.400 Project B is recommended for acceptance because it has the higher positive NPY. At the alternative rate of 14% whieh is higher than the JRR of the incremental cash flows, the previously less preferred project i.e project B will become the more preferred, UNIQUE IRR One of the major disadvantages of IRR is that when dealing with non-conventional cash flows, it could produce a multiple IRR which is not good for decision making The concept of unique IRR proposed by some Analysts on the ground that there exists a UNIQUE IRR as against the multiple IRR, is calculated based on the company’s cost of capital as follows financial management n 95 Chapter 5 ital Expenditure Decisions ‘Step I:Adjust each year's cash flow by one yea (He reduce each cash flow’s actual year by one) Please do not adjust the year of the outlay: ler removing one year from each ‘ihe outlay to obtain the adapted NPY. Step 2:Appraise the project in its new state i 8 cash flow’s original year excluding that o 100% ‘Step 2:Divide the adapted NPV by the outlay and multiply by This is the unique IRR. QUESTION 5-11: Bayelsa Nigeria Ple, a company witha cost of capital of tion formula to calculate the IRR of a new project but 15 (0% has been using the interpola- producing inconsistent results. “The project's cash flow is as follows: Year 0 1 2 Cash flow(N) (250,000) 555,000 (307,400) (a) Find NPV ofthe project for several values of discount rate in the range 0% 10.20%, (6) Plot graph of NPV against discount rate (6) Calculate a unique IRR and show on the above graph along, (a) Comment on the graph. with the multiple IRR, SOLUTION 5-11: (a) NPVS at represented rates of 0%, 5%, 10%, 15%, 20% Yr 0) DF@ 0% PVN) 0 (250,000) 1 (250,000) 1 585,000 1 555,000 2 (307,400) 1 307,400) 2400) Yr CF) DF @ 5% PV(N) 0 (250,000) 1 (250,000) 1 $55,000 9524 528,582 2 (307,400) 9070 278,812) 230) financial management 6 esis Ce (b) pier $ Capital Expenditure Decisions CRN) PVN) (250,000) 1 (250,000) 5 9091 504,551 8264 (254.035, ob CF(N) DF @ 15% PV(N) (250,000) 1 (250,000) 555,000 8696 482,628 (307,400) 7561 (232.425) 203 CF(N) DF @ 20% PV(N) (250,000) 1 (250,000) 555,000 $333 462,482 (307,400) 6944 (213.459) (977) Rates% 0, 5, 10, 15, 20 NPVs. (2,400) (230) 516 203 (977) 1,000 IRR IRR 500- Unique IRR 10.22% Financial management oF Chapter 5 Capital Expenditure Decisions () CALCULATION _OF UNIQUE _IRR Yr CRON) UNIQUE CRIN), DF@I0% Pv) YEAR 0 (250,000) 0 (250,000) I (250,000) 1 55,0000 555,000 1 555,000 2 (307,400) 1 (307,400) 909! (279.457) 25.543 Unique IRR = _Adapted NPV x 100 Original Outlay me = _N25,543 x 100% 250,000 Unique IRR = js thatthe higher the rate, the higher the I the profit be Dblem associated with IRR when ed fundamental (@ One of the fundamental principles in finance interest that will be payable and the lower wi ‘The graph has apparently reflected the damaging prol dealing with non-conventional cash flows as the above sta assumption has been faulted in this question, ‘At no cost of capital 1e 0%, the NPV is N2,400 negative, the graph produced the ‘worst steep at this rate which should not be while at 5% the NPV improved to become (N230) instead of worsening. To make matters worse, the project produc: applied, the NPV reduced to become N203 positive, This isin lin fundamental principle in finance. ‘At 20% the NPV recorded N977 negative. T .ed positive NPV of 516 at 10%. If 15% is e with the This should have been the worst NPV. QUESTION 5-12: Radio Lawal manufactures plastic chairs, selling price N10.50 each. He began business ‘one year ago by buying a machine costing N160,000 to make chairs. The scrap value of the machine afier 6 years is expected to be N10,000. The expected trade-in value after | year is N30,000. ‘Anticipated annual operating costs are as follows: Direet labour ~ N70 per machine hour, Direct material ~ N2 per chair, Variable overheads N3.50 per chair. Market research suggests that 80,000 chairs can be sold each year. Financial management Chapter 5_ Capital Expenditure Decisions Expected production is 60,000 chairs per annum, based on a 50- -week year, S-day week, 8-hour day, An improved version of the machine has now come to the market; this can produce an additional 15 chairs per hour, and it costs N400,000. Anticipated annual cost up to a production of 60,000 chairs per annum are unchanged. However, in any one year, on any production over 60,000 chairs, variable overheads reduce 10N2.50 per chair and suppliers give a 10% discount on the additional raw materials. The scrap value of the new machine, afier $ years is expected to be N5,000. Radio Lawal is considering buying the new machine and trading in the old machine at the end of the first year of operation. ‘The current cost of capital is 14% per annum. Required: (a) Advise Radio Lawal whether or not to trade in the existing machine for the new one (b) Determine the break-even cost of capital, SOLUTION 5-12: Workings 1, Additional Production: 15x8x5x50 = 30,000 Available market = 80,000-60,000 20,000 ‘Therefore additional production should be limited to 20,000 units. 2. Additional Costs: Materials: 20,000 x N2 x 0.90 Variable overheads: 20,000 x N2.50 Note that there are no additional labour costs as no extra labour hour will be incurred. As labour is paid per hour and as no extra labour hour is worked, no additional labour cost will 3. Extra Contributi N Additional sales 20,000 x N10.50 210,000 Extra costs 86,000 Financial management 99 4. Incremental Outlay: Cost of new machine Scrap value of existing machine 5. Serap Value: New machine Existing machine (a) NPV Calculation item Outlay Contribution Scrap value (6) IRR Calculation Item YR Outlay 0 Contribution 15 Scrap value 5 IRR= 14 + N 400,000 (30,000) N 5,000 10,000) 6.000) CRIN) = DCR@14% PVN) 370,000) 1 (370,000) 124,000 3.43 425,320 (65,000) 052 2,600) 52.720 cr) DCR@20% | PVE) (370,000) 1 (370,000) 124,000 299 370,760 (5,000) 0.40 (2.000) 1.240) (20-14) 52,720 + 1,240 = 19.86% QUESTION 5-13: Ekimogun Nigeria Limited manufactures thermostat that can be used ina range of kitchen appliance. The manufacturing process i, at present, semi-automated. The equipment used cost N540,000 and has a written-down value for N300,000, Demand for the product has. been fairly stable and output has been maintained at 50,000 units per annum in recent years. The following data, based on the current level of output, has been prepared in respect of the product. Selling price Per Unit N 12.40 financial management 100 Chapter 5. Capital Expenditure Decisions Less Labour 3.30 Materials 3.65 Overheads — variable 158 = fixed 1.60 10.13 Profit man Although the existing equipment is expected to last for a further four years before itis sold {for an estimated N40,000, the company has recently been considering purchasing new equipment which would completely automate much of the production process. The new ‘equipment would cost N670,000 and would have an expected life of four years at the end of which it would be sold for an estimated N70,000. If the new equipment is purchased the old ‘equipment could be sold for N150,000 immediately. The assistant to the company accountant has prepared a report to help assess the viability of the proposed change which includes the following data: Per Unit N N Selling price 12.40 Less: Labour 1.20 Materials 3.20 Overheads ~ variable 140 ~fixed 3.30 9.10 330 Depreciation charges will increase by N85,000 per annum as a result of purchasing the new ‘machinery; however, other fixed costs are not expected to change. In the report the assistant wrote: ‘The figures shown above which relate to the proposed change are based on the current level of output and take account ofa depreciation charge of N150,000 per annum in respect of the new equipment. The effect of purchasing the new equipment will be to increase the ‘et profit to sales ratio from 18.3% to 26.6%. In addition, the purchase ofthe new equipment will enable us to reduce our stock level immediately by N130,000, In view of these facts I recommend purchase of the new equipment’ The company has a cost of capital of 12%. Ignore taxation. Required: Provide calculations to advise the company whether the new equipment shouldbe purchased. Fingneial management T0r *hapter 5 Capital Expenditure Decisions SOLUTION 5-13: Working Notes 1 E existing equipment are irrelevant. Net Outlay Cost of new machine Current resale value of existing machine Net outlay Incremental Annual Cash flow old New N N Selling price 12.40 12.40 ‘Variable costs, (8.53) Unit contribution 3.87 6.60 Sales volume Total annual ineremental contribution Serap Value ‘New machine Existing machine Incremental isting Equipment: The original cost and written down value of the N 670,000 (150,000) 520,000 Incremental N 2.73 50,000 N136, 500 N 70,000 (40.000) 30.000 Note that if the existing machine is sold now, the opportunity to sell it in four years’ time is lost. The scrap value, of N40, 000 is therefore treated as outflow. Fixed Costs: These are non-incremental fixed costs and should be disregarded, Besides, the ratio of profit to sales is irrelevant. Calculation of NPV tem YR CF(N) DCF PV(N) at 12% Outlay 0 (520,000) 1 (520,000) Stock 0 130,000 1 130,000 Contribution 14 136,500 3.04 414,960 Scrap value 4 30,000 0.64 19.200 44,160 102 financial management as Capital Expenditure Decisions Cancinsion: With's positive NDVte projec if webepuble. other factors Temaining constant, MODIFIED IRR (CIMA) ‘To help overcome the problems of IRR, a recent i fied invernal rate of return (MIRR), which acco: in Management Accounting as follows: innovation is the development of the modi- ding to Lefley (1997) has been described The MIR is according to Lumby, “a cosmetic restatement of an NPV analysis”. This is not, however, exactly the case as the MIRR does address some of the deficiencies of the conventional JRR. It eliminates multiple /RR rates; it addresses the re-investment rate issue and reduces overoptimism:; and produces result which, when ranking projects, is consistent with the NPV rule, Using this method all eash flows after the initial investment are converted, by assuming that the cash flows can be reinvested at the cost of capital, to a single cash inflow at the end of the projet’ life. ‘The MIRR is obiained by assuming an outflow in year 0 and a single inflow at the end of the final year of the project. ‘Aste figure forthe cash inflow in the final year ofa project has been arrived at by assume ing a reinvestment rate equal to the cost of capital and not at the project’s IRR (which will normally be in excess of the cost of capital) then the actual yield from a project will be more realistic when using the MIRR method. Illustration 5-14 Calculate the MIRR of a project requiring an outlay of N40,000 and having the following cash flow profile. The cost of capital is 8%. Year Cash flow N 1 13,000 2 15,500 - 11,500 4 9,500 4 7,500 Solution 5-14 “The net cash flows from the project for years 1 to 5 are compounded at the same rate as. ‘he cost of capital (investment rate) into a single figure for year 5 financial management ae ee eae reinvestment rate N factor N 13,000 1.3605 17,686 i 15.500 1.2597 19.596 ? 11,500 1.1664 13.414 ‘ 9,500 1.0800 10.260 : 7.500 1.0000 1500 Oand ‘ MIRR of the project (based ona cash outflow of N40,000 in year 0 anda single cash into in year 5 of N68,386) is 11.3%. ‘The MIRR is calculated as follows: ae 140,000 Discount factor Far Cash flows NGB3EG = 0.5849 be used for MIRR- = “The result obtained is to be traced from the mathematical tables as it relates to the last year of the project’ life span, (The result will be between two rates). By interpolation. Disbount factor at lower_rate - Discount factor obtained _for MIRR [I Higher rate] Discount factor at lower rate~ Discount factor at higher rate laa Lower rat

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