QUESTION ONE

The Zeda Company Ltd. is considering a substantial investment in a new production process. From a variety of sources, the total cost of the project has been estimated at Sh.20 million. However, if the investment were to be increased to Sh.30 million, the productive capacity of the plant could be substantially increased. Due to the nature of the process, it would be exorbitantly expensive to increase capacity once the equipment is installed.

Once of the problems facing the company is that there is a considerable degree of uncertainty regarding demand for the product. After some research which has been conducted jointly by the marketing and finance departments, some data has been produced. These are shown below:

Investment A (Sh.20 m)

Investment B (Sh.30m)

 

Year

Demand Probability

Annual Net Cash Flow

Demand Probability

Annual Net Cash Flow

 

 

 

Sh.(million)

 

Sh.(million)

1.

1 - 4

0.4

6

0.3

10

 

5 - 10

0.4

5

 

7

2.

1 - 4

0.4

6

0.5

8

 

5 - 10

 

2

 

4

3.

1 - 10

0.2

2

0.2

1

Cost of capital for the firm is 10%.

REQUIRED:

(a) Prepare a statement which clearly indicates the financial implications of each of the two alternative investment scenarios.(12 marks)

(b) Comment on other matters which the management should take into account before reaching the final decision.(10 marks)

(Total: 22 marks)

PVIFA: 10% 5 years = 3.79

PVIFA: 10% 10 years = 6.14

PVIFA: 10% 10 years = 0.62

 QUESTION TWO

(a) Explain the concept of "rate of interest" in the context of financial decisions.(5 marks)

(b) The Mentala Plastics Company has been dumping in the local council waste collection centre some 30,000 Kg. of unusable chemicals each year. In addition to being an eyesore, the residents of a nearby estate have started complaining of bad odour emanating from the dump and suspect that the company is to blame.

 The company has received information that these chemicals can be recycled at relatively little cost. The equipment to do it is however rather expensive and, in addition, the chemicals recovered are of a relatively poor quality. Investigations have shown that these chemicals can be sold to another firm at an average price of Sh.35 per Kg. The direct cost of recycling has been calcultated at Sh.15 per Kg. but this is before depreciation and taxes.

 The equipment for this process has an expected life of 10 years and a current cost of Sh.2 million. At the end of the ten years, it will be virtually worthless.

 For financial analysis, the company uses the straight line method of depreciation and an average tax rate of 40%. It has a required rate of return of 15%.

 REQUIRED:

i. Compute the project's net present value (N.P.V).

ii. Compute the payback period and the accounting rate of return.

iii. Compute the internal rate of return (IRR).

iv. Should this project be undertaken? Explain.

 Are there any other important matters that the company should consider in evaluating this project?

 QUESTION THREE

A piece of equipment requiring the investment of 2.2 million is being considered by Charo Foods Ltd. The equipment has a ten-year useful life and an expected salvage value of Sh 200,000. The company uses the straight-line method of depreciation for analysing investment decisions and faces a tax rate of 40%. For simplicity assume that the depreciation method is acceptable for tax purposes.

 A pessimistic forecast projects cash earnings before depreciation and taxes at Sh 400,000 per year compared with an optimistic estimate of Sh 500,000 per year. The probability associated with the pessimistic estimate is 0.4 and 0.6 for the optimistic forecast. The company has a policy of using a hurdle rate of 10% for replacement investments, 12% (its cost of capital) for revenue expansion investments into existing product lines and 15% projects involving new areas or new product lines.

 REQUIRED:

(a) Compute the expected annual cash flows associated with the proposed equipment investments.

(4 marks)

(b) Would you recommend acceptance of this project if it involved expansion of sales for an existing product?(5 marks)

(c) Would it be acceptable if it was for the replacement of equipment with a book value of Sh 200,000 at the end of the tenth year but which could be sold at that time for only Sh 40,000? (5 marks)

(d) Discounted cashflow methods were developed for idealised settings of complete and perfect capital, factor and commodity markets. Explain what complications arise when an attempt is made to apply these methods in real life markets that are neither complete nor perfect. (6 marks)

(Total: 20 marks)