Specific Investment Decisions

SPECIFIC INVESTMENT DECISIONS

Q1. If a company leases rather than buy an asset, which of the following will not be a benefit to the purchaser? (MCQ)Avoiding Tax exhaustionExploiting a low cost of capital Attract lease customers Potential future scrap(2 marks)

Q2. Willow Co has already decided to accept a project and is now considering how to finance the project. The asset could be leased over three years at a rental of $23,000 per annum, payable at the start of each year. Tax is payable at 25%, one year in arrears. The post-tax cost of borrowing is 8%. Calculate the net present value of the leasing option. (FIB)Years Cash flows ($)0 – 2 Rentals (23,000)2 – 4 Tax relief 5,75041084542545000NOTE: Negative answer should be shown with a negative sign (-)$(2 marks)

Q3. Select the correct Lease option based on the statements given. (HA)It is a rental agreement OPERATING FINANCEMaintenance & Servicing cost of Lessee OPERATING FINANCEAgreement for the useful life of the asset OPERATING FINANCEIncluded in the balance sheet of the Lessor OPERATING FINANCE(2 marks)

Q4. Tango Co. needs to decide about an asset that will be used in a project. The company has an option to either Buy the asset or Lease it. If Tango Co. opts for Buy option the following information is given: The asset is bought using a bank loan for $400,000 for a time period of three years. The scrap value of the asset is $30,000 & annual maintenance cost will be $12,000 per annum. Calculate the present value for year two using a cost of borrowing of 5% (ignoring taxation)? (MCQ)$30,000$(11,424)$(10,884)$15,552(2 marks)

Q5. What are the relevant cash flows for the Buy option? (MRQ)Investment and Disposal proceed repair & Maintenance costTax allowable depreciationTax saving on Servicing cost(2 marks)

Q6. Beamer Co. wants to replace a Dyeing machine on 31st December 2017. The machine is expected to cost $360,000 if purchased immediately, payable on 31st December 2017. After four years the company expects technological changes in the market making this machine redundant and leaving a scrap value of $20,000 on 31st December 2021. Capital allowance on a 25% reducing balance basis. A full year allowance is given for acquisition but no writing down allowance in the year of disposal. If the maintenance cost is $15,000 per year payable at each year-end & tax rate is 30%. What will be the Balancing Charge/Allowance? (MCQ)$28,172 Balancing Charge$27,000 Balancing Allowance$11,391 Balancing Charge$28,172 Balancing Allowance(2 marks)

Q7. Putin Co has decided to invest in a new machine which has a ten-year life and no disposal proceeds. The machine can either be purchased now for $55,000, or it can be leased for ten years with lease rental payments of $10,000 per annum payable at the end of each year. The cost of capital to be applied is 11% and taxation should be ignored. What should be done? (MCQ)Purchase the machine lease the machine sale or LeasebackDo nothing(2 marks)

Q8. A machine is leased using operating lease & the annual lease rental for six years will be $67,000 payable at each year-end. The first rental will be payable at the start of year one. Calculate net present value using a cost of capital of 13%? (FIB) 3816353683000$(2 marks)

Q9. A machine is leased using finance lease & the annual lease rental for three years will be $95,000 payable at each year-end. The first rental will be payable at the end of year zero in advance. The maintenance cost is $10,000 per annum for three years. Calculate net cash flow for year two using a tax save rate of 30% recording in the year cash flow arises? (MCQ)$(66,500)$(73,500)$(7,000)$28,500(2 marks)

Q10. “Assets with unequal lives cannot be compared to a comparison will not be like with like”. Which of the following option relates to the above statement? (MCQ)Equivalent annual cost profitability indexAsset Replacement decision probability analysis (2 marks)

Q11. Project A with an NPV of $4m with a six-year duration. Project B with an NPV of $5m with a seven-year duration. Project C with NPV of $6m with a three-year duration. The cost of capital is 12%. Which of the following will be ranked second? (MCQ)Project AProject project CNone of the above(2 marks)

Q12. The net present value of the costs of operating a machine for the next three years is $10,437 at a cost of capital of 16%. What is the equivalent annual cost of operating the machine? (FIB)4114806477000$ (2 marks)

Q13. KD Co. is deciding to replace cargo planes every year or every two years. The initial cost of the plane is $200,000. The maintenance charges are as follows: The first year it’s Nil; $25,000 at the end of the second year. The second-hand value would fall from $110,000 to $90,000 if it held on the plane for two years instead of one year. KD Co’s cost of capital is 4%. How often should KD Co. replace their cargo planes % what will be the equivalent annual cost of the option they choose? (MCQ)Replace every 1 year $(94,180). Replace every 1 year $(97,900)Replace every 2 years $(139,875).ьReplace every 2 years $(48,450)(2 marks)

Q14. Which of the following statements is/are a limitation for Asset Replacement Decision? (MRQ)Replacement made every time is better than the previous asset assets replaced have same cash inflows every year assumed that Machines replaced have different operational efficiencies than the previous asset ignores environmental damage(2 marks)

Q15. Capital Rationing is the restriction on organizations’ ability to invest in all projects due to insufficient funds. Select the relevant statements whether they are true or false. (HA)Hard Capital Rationing is the limit on the amount of finance available imposed by the lending institutions TRUE FALSESoft Capital Rationing is the limit on the amount of finance available imposed by the lending institutions TRUE FALSEProfitability index is a solution applicable to divisible projects only TRUE FALSETrial; Error method is the solution applicable to divisible projects only TRUE FALSE(2 marks)

Q16. Riddle Co. is appraising three investment projects but is experiencing a capital rationing in Year 0. No capital rationing is expected in the future, but all the projects are important for the company and cannot be delayed; a decision needs to be taken. Riddle Co.’s cost of capital is 6%. Which order should the projects be ranked?

The following information is available: (MCQ)Project The outlay in year 0 ($) Present Value ($) Net Present Value ($)Jeremy 115,000 121,900 12,190James 43,000 45,580 13,674Richard 75,000 79,500 47,700Jeremy, Richard, JamesJames, Jeremy, Richard Richard, James, JeremyJeremy, James, Richard (2 marks)

Q17. What is an indivisible project? It is the ratio of the NPV of a project to its investment cost is the project that must be undertaken completely or not at all is the project that must be undertaken completely or partially is the project restriction due to insufficient funds(2 marks)The following information relates to Q18 ;

Q19.Schneider Co. is facing a capital constraint of $150m immediately available for investment. The investments in possible projects are: Project Initial Cost ($m) NPV ($m)W 30 7X 70 12Y 60 12Z 40 16

Q18. If the projects are divisible, what is the NPV generated from the optimum investment program? (FIB)35115524765 00 $ Million(2 marks)

Q19. If the projects are indivisible, what is the NPV generated from the optimum investment program? (MCQ)$19m$24m$28m$35m(2 marks)

Q20. Place the calculation steps of the Profitability index in the correct order. (P;D)Monitor the investment made in the project 1Calculate profitability index of each project 2Allocate the funds 3Rank the project 4(2 marks).

INVESTMENT DECISIONS (ANSWERS)

Q1. AAvoiding tax exhaustion is a benefit for lessee rather than the purchaser. Tax exhaustion is when a business has negative taxable income so cannot benefit from tax saving.Exploiting a low cost of capital is a benefit for the purchaserAttracting lease customers is a benefit to a lessorPotential future scrap is a benefit for the purchaser as the lessee is not entitled to future scrap proceeds

Q2. $-50,289Years Cash flows ($) Discount Factor (8%) Present value ($)0 – 2 Rentals (23,000) 1 + 1.783 (64,009)2 – 4 Tax relief 5,750 3.312 – 0.926 13,720NPV (50,289)

Q3. CIt is a rental agreement OPERATING  Maintenance ; Servicing cost of Lessee FINANCEAgreement for the useful life of the asset FINANCEIncluded in the balance sheet of the Lessor OPERATING

Q4. Year 0 1 2 3Investment / Scrap value (400,000) 30,000Maintenance (12,000) (12,000) (12,000)Net Cash flow (400,000) (12,000) (12,000) 18,000DF 5% 1 0.952 0.907 0.864Present value (400,000) (11,424) (10,884) 15,552

Q5. All cash flows are relevant for Buy option

Q6. DYear 2017 2018 2019 2020 2021 2022Investment / Scrap value (360,000) 20,000 Tax save 27,000 20.250 15,188 11,391 28,172Workings:2017 (360,000 × 25%) = 90,000 × 30% = 27,0002018 (90,000 × 0.75) = 67,500 × 30% = 20,2502019 (67,500 × 0.75) = 50,625 × 30% = 15,1882020 (50,625 × 0.75) = 37,969 × 30% = 11,391Balancing Allowance (113,906 – 20,000) = $ 28,172

Q7. APresent value of leasing costs PV = Annuity factor at 11% for 10 years × $10,000 = 5.889 × $10,000 = $58,890 If the machine was purchased now, it would cost $55,000. The purchase is therefore the least-cost financing option, hence choosing the purchase option.

Q8. $ – 267,866$67,000 × 3.998 (annuity factor for 6 years) = $ – 267,866

Q9. BYear 0 1 2 3Lease rentals (95,000) (95,000) (95,000) Maintenance (10,000) (10,000) (10,000)Tax save 30% (LR) 28,500 28,500 28,500 (M) 3,000 3,000 3,000Net cash flow (66,500) (73,500) (73,500) (7000)

Q10. CEquivalent annual cost is method of converting asset lives to be like with likeProfitability index is the method to overcome capital rationingAsset Replacement decision is correctProbability analysis is method under risk ; uncertainty

Q11. BProject A = $4 ÷ 4.111 (AF 6 years) = $0.973mProject B = $5 ÷ 4.564 (AF 7 years) = $1.096mProject C = $6 ÷ 2.402 (AF 3 years) = $2.498m

Q12. $4,647EAC = $10,437 ÷ 2.246 (AF 3 years) = $4,647

Q13. DYear 1 Year Cash flow ($) DF (4%) PV ($)0 (200,000) 1 (200,000)1 110,000 0.962 105,820NPV (94,180)EAC = 94,180 ÷ 0.962 = 97,900Year 2 Year Cash flow ($) DF (4%) PV ($)0 (200,000) 1 (200,000)1 – 0.962 -2 (25,000) + 90,000 0.925 60,125NPV (139,875)EAC = 139,875 ÷ 2.887 = 48,450

Q14. Assets replaced have same cash inflows every year ; it ignores environmental damageReplacement made every time is like with likeAssets replaced have same cash inflows every year (limitation)Assumed that Machines replaced have same operational efficiencies like the previous assetIt ignores environmental damage, It ignores non-financial aspects (limitation)

Q15.Hard Capital Rationing is the limit on the amount of finance available imposed by the lending institutions TRUE Soft Capital Rationing is the limit on the amount of finance available imposed by the lending institutions FALSE

Profitability index is a solution applicable to divisible projects only TRUE Trial ; Error method is the solution applicable to divisible projects onlyFALSESoft Capital Rationing is the limit on the amount of finance available imposed by the company itself.Trial ; Error method is the solution applicable to indivisible projects only

Q16. D. Jeremy, James, RichardProject The outlay in year 0 ($) Present Value($) Net Present Value ($) Profitability IndexJeremy 115,000 121,900 12,190 0.1James 43,000 45,580 13,674 0.3Richard 75,000 79,500 47,700 0.6Jeremy = (12,190 ÷ 121,900) = 0.1James = (13,674 ÷ 45,580) = 0.3Richard = (47,700 ÷ 79,500) = 0.6

Q17. BIt is the ratio of the NPV of a project to its investment cost (Profitability index)It is the project that must be undertaken completely or not at all (Indivisible project)It is the project that must be undertaken completely or partially (Divisible project) It is the project restriction due to insufficient funds (Capital rationing)

Q18. $38.4mProject Profitability Index Ranking Investment ($) NPV ($)W ( 7 ÷ 30) = 0.23 2 30 ×0.23 7X ( 12 ÷ 70) = 0.17 4 20 × 0.17 3.4Y ( 12 ÷ 60) = 0.2 3 60 × 0.2 12Z ( 16 ÷ 40) = 0.4 1 40 × 0.4 16Total 150 38.4

Q19. D Combination:W + X Cost $100m NPV $19mW + Y + Z Cost $130m NPV $35mX + Y Cost $130m NPV $24mX + Z Cost $110m NPV $28mY + Z Cost $100m NPV $28m

Q20. Monitor the investment made in the project. Calculate profitability index of each project.