Question Tag: Cost of Capital

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FM – Nov 2016 – L3 – Q4 – International Financial Management

Evaluate a foreign investment decision for Gugi Plc, including cash flow, tax, and exchange rate considerations.

Question

Gugi Plc. is a highly successful manufacturing company operating in Nigeria. In addition to sales within Nigeria, the company also exports to a foreign country (with currency F$) along the ECOWAS sub-region. The export sales generate annual net cash inflow of ₦50,000,000.

Gugi Plc. is now considering whether to establish a factory in the foreign country and stop export from Nigeria to the country. The project is expected to cost F$1 billion, including F$200 million for working capital.

A suitable existing factory has been located, and production could commence immediately. A payment of F$950 million would be required immediately, with the remainder payable at the end of year one. The following additional information is available:

Details	Figures
Annual production and sales	110,000 units
Unit selling price	F$5,000
Unit variable cost	F$2,000
Unit royalty payable to Gugi Plc	₦300
Incremental annual cash fixed costs	F$50 million

Assume that the above cash items will remain constant throughout the expected life of the project of 4 years. At the end of year 4, it is estimated that the net realizable value of the non-current assets will be F$1.40 billion.

It is the policy of the company to remit the maximum funds possible to the parent (i.e., Gugi Plc.) at the end of each year. Assume that there are no legal complications to prevent this.

If the new factory is set up and export to the foreign country is stopped, it is expected that new export markets of a similar worth in North Africa could replace the existing exports. Production in Nigeria is at full capacity, and there are no plans for further capacity expansion.

Tax on the company’s profits is at a rate of 40% in both countries, payable one year in arrears. A double taxation agreement exists between Nigeria and the foreign country, and no double taxation is expected to arise. No withholding tax is levied on royalties payable from the foreign country to Nigeria.

Tax-allowable “depreciation” is at a rate of 25% on a straight-line basis on all non-current assets.

The Directors of Gugi Plc. believe that the appropriate risk-adjusted cost of capital of the project is 13%.

Annual inflation rates in Nigeria and the foreign country are currently 5.6% and 10%, respectively. These rates are expected to remain constant in the foreseeable future. The current spot exchange rate is F$1.60 = ₦1. You may assume that the exchange rate reflects the purchasing power parity theorem.

Required:

(a) Evaluate the proposed investment from the viewpoint of Gugi Plc.
Notes:

Show all workings and calculations to the nearest million.
State all reasonable assumptions. (18 Marks)

(b) State two further information and analysis that might be useful in evaluating this project. (2 Marks)

Answer

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Tags: Cost of Capital, Exchange Rate, Foreign Investment, Inflation, Net Present Value
Level: Level 3

Topic: International financial management

FM – Nov 2016 – L3 – Q1 – Investment Appraisal Techniques

Evaluate TP’s project considering current market values and assess the risk-adjusted cost of capital.

Question

Tinko Plc (TP) repairs and maintains heavy-duty trucks, with workshops in Nigeria and several other African countries. TP is considering an expansion project in response to the government’s recent policy aimed at encouraging mechanized farming through the “Graduates Back To Land (GBTL)” program, which will likely increase demand for heavy-duty machinery.

Below are extracts from the most recent Statement of Financial Position of TP:

Item	₦’million
Share capital	200
Reserves	320
Non-current liabilities	760
Current liabilities	60
Total	1,340

TP’s Free Cash Flows to Equity (FCFE) is currently estimated at ₦153 million, and it is expected to grow at 2.5% per annum indefinitely. The equity shareholders require a return of 11%.

The non-current liabilities consist entirely of bonds redeemable in four years at par with a coupon rate of 5.4%. The debt is rated BB, and the credit spread on BB-rated debt is 80 basis points above the risk-free rate.

In light of the GBTL program, TP is contemplating entry into the mechanized farming support industry through a four-year project, recognizing that after four years, competition may intensify significantly.

The project requires an initial investment of ₦84 million and is expected to generate the following after-tax cash flows:

Additional Information:

Scenario Adjustments:
- There is a 25% probability that the GBTL program will not grow as expected in the first year. If this occurs, the present value of the project’s cash flows over its four-year life will be 50% of the original estimates.
- If the GBTL program grows as expected in the first year, there is still a 20% probability that growth will slow in subsequent years, reducing the present value of cash flows to 40% of the original estimates for those years.
Sale Option: Feedwell Limited (FL) has offered ₦100 million to buy the project from TP at the start of the second year. TP is evaluating if this option adds strategic value to the project.
Abako Plc, a comparable company, operates primarily in non-agricultural services, similar to TP, and has an equity beta of 1.6. Abako derives approximately 80% of its revenues from services outside agriculture, with an asset beta of 0.80. Abako’s capital structure consists of 80 million shares trading at ₦4.50 per share and debt of ₦340 million.
The debt is trading at ₦1,050 per ₦1,000 with a zero debt beta.
Risk-free rate: 4%; Market risk premium: 6%; Corporate tax rate: 20%.

Requirements: a. Calculate TP’s current total market value of:

i. Equity (3 Marks)
ii. Bonds (4 Marks) b. Determine the risk-adjusted cost of capital for the new project (to the nearest percent) (10 Marks) c. Estimate the value of the project:
i. Without factoring in the potential strategic value or synergy from the project (5 Marks)
ii. With FL’s offer, assuming it reflects the market’s view of the project’s value (5 Marks) d. Clearly state the assumptions made in your calculations (3 Marks)

Answer

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Tags: Cost of Capital, Debt Valuation, Equity Valuation, Market Value, Project Valuation, Risk Adjustment
Level: Level 3

Topic: Investment Appraisal Techniques

FM – May 2024 – L3 – SC – Q6 – Financial Distress and Bankruptcy

Discuss economic exposure in currency risk management and calculate impact of USD strengthening on Linko Plc’s market value.

Question

(a) With respect to foreign currency risk management, explain economic exposure and discuss generally how a company can manage economic exposure. (8 Marks)

(b) Linko Plc is a UK-based company supplying medical equipment to the USA and Europe, while importing raw materials from the USA. It has net imports of 8 million dollars from the USA, which is expected to continue for the next six years. The company’s cost of capital is 10% per year. Assume cash flows occur at year-end and ignore taxation.

Required:
Assuming no change in the physical volume or dollar price of imports, estimate the impact on the expected market value of Linko Plc, if the market expects the dollar to strengthen by 4% per year against the pound. The current spot exchange rate (US$ per £1) is 1.9156 – 1.9210. (7 Marks)

Answer

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Tags: Cost of Capital, Currency Management, Economic Exposure, Foreign Exchange, Market Value Impact, Spot Rate
Level: Level 3

Topic: Financial Distress and Bankruptcy
Series: MAY 2024

FM – Nov 2018 – L3 – Q5 – Capital Budgeting under Uncertainty

Analyze whether replacing a machine after three or four years is more beneficial based on economic costs and tax implications.

Question

Kuku Plc. had a need for a machine. After four years of purchase, the machine will no longer be capable of efficient working at the level of use by the company. The company typically replaces machines every four years. The production manager has noted that in the fourth year, the machine will require additional maintenance to maintain normal efficiency. This raises the question of whether the machine should be replaced after three years instead of four years, as per company practice.

Relevant information is as follows:

(i) A new machine will cost N240,000. If retained for four years, it will have zero scrap value at the end. If retained for three years, it will have an estimated disposal value of N30,000. The machine qualifies for capital allowance of 20% on a reducing balance basis each year, except in the last year. In the final year, if the disposal proceeds are less than the tax written-down value, the difference will be an additional tax relief.

The machine is assumed to be bought and disposed of on the last day of the company’s accounting year.

(ii) The company tax rate is 30%, payable on the last day of the relevant accounting year.

(iii) Maintenance costs are covered by the supplier in the first year. In the second and third years, maintenance costs average N30,000 annually. In the fourth year, they increase to N60,000. Maintenance costs are tax-allowable and payable on the first day of the accounting year.

(iv) The company’s cost of capital is 15%.

Required:

a. Prepare calculations to determine whether it is economically beneficial to replace the machine after three years or four years. (12 Marks)

b. Discuss two additional factors that could influence the company’s replacement decision, including any potential weaknesses in the decision criteria. (3 Marks)

Answer

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Tags: Capital Allowance, Cost of Capital, Disposal Value, Economic Benefit, Machine Replacement, Maintenance Costs, Tax implications
Level: Level 3

Topic: Capital Budgeting under Uncertainty

FM – Nov 2022 – L3 – Q3 – Financing Decisions and Capital Markets

Evaluate the financing structure and calculate required return, WACC, and factors influencing beta.

Question

Zakai (ZK) Plc is a listed company that owns and operates a large number of farms throughout the country. A variety of crops are grown.

Financing Structure:
The following is an extract from the statement of financial position of ZK Plc as at 30 September 2021:

The ordinary shares were quoted at ₦3 per share ex div on 30 September 2021. The beta of ZK Plc’s equity shares is 0.8; the annual yield on treasury bills is 5%, and financial markets expect an average annual return of 15% on the market index.

The market price per preference share was ₦0.90 ex div on 30 September 2021. Loan stock interest is paid annually in arrears and is allowable for tax at 30%. The loan stock was priced at ₦100.57 ex interest per ₦100 nominal on 30 September 2021. Loan stock is redeemable on 30 September 2022.

Assume that taxation is payable at the end of the year in which taxable profits arise.

A New Project:
Difficult trading conditions have caused ZK Plc to decide to convert a number of its farms into camping sites with effect from the 2022 holiday season. Providing the necessary facilities for campers will require major investment, and this will be financed by a new issue of loan stock. The returns on the new campsite business are likely to have a very low correlation with those of the existing farming business.

Required:

a. Using the capital asset pricing model, calculate the required rate of return on equity of ZK Plc as at 30 September 2021. Ignore any impact from the new campsite project. (3 Marks)

b. Briefly explain the implications of a beta of less than 1, such as that for ZK Plc. (2 Marks)

c. Calculate the weighted average cost of capital (WACC) of ZK Plc as at 30 September 2021 (use your calculation in answer to requirement (a) above for the cost of equity). Ignore any impact from the new campsite project. (10 Marks)

d. Without further calculations, identify and explain the factors that may change ZK Plc’s equity beta during the year ending 30 September 2022. (5 Marks)

(Total 20 Marks)

Answer

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Tags: Beta Analysis, CAPM, Cost of Capital, Equity Valuation, Financing Structure, Investment decisions
Level: Level 3

Topic: Financing Decisions and Capital Markets
Series: NOV 2022

FM – Nov 2022 – L3 – Q2 – Financing Decisions and Capital Markets

Evaluating financing options (rights issue vs convertible loans) for Balama Plc's expansion.

Question

Balama Plc. (Balama) is a listed manufacturer of dairy products. In recent years, the company has experienced only a modest level of growth, but following the recent retirement of the chief executive, his replacement is keen to expand Balama’s operations.

The board of directors has recently agreed to support a proposal by the new chief executive that the company purchase new manufacturing equipment to enable it to expand its range of dairy products. The new equipment will cost N50 million, and the company is seeking to raise new finance to fund the expenditure in full. However, the board of directors is undecided as to how the new finance is to be raised. The directors are considering either a 1 for 5 rights issue at a price of N2.50 per share with a theoretical ex-rights price of N2.92 or a convertible loan of N50 million.

The loan will be secured against the company’s freehold land and buildings. The company’s share is presently quoted at a price of N3.00 per share.

Required:

a. Explain the terms ‘rights issue’ and ‘convertible loans’. (3 Marks)

b. Explain how the ‘theoretical ex-rights’ price of N2.92 is calculated and why the actual price might be different. Show your workings. (4 Marks)

c. Prepare a report for the board of directors that fully evaluates the two potential methods of financing the company’s expansion plans. (13 Marks)

(Total 20 Marks)

Answer

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Tags: Convertible Loans, Cost of Capital, Equity Financing, Financial strategy, Financing Expansion, Loan financing, Rights Issue, Shareholder Value
Level: Level 3

Topic: Financing Decisions and Capital Markets
Series: NOV 2022

PM – Nov 2024 – L2 – Q7b – Divisional Performance Measurement

Evaluating division performance using ROI and residual income methods with adjusted cost of capital.

Question

Ngerige and Sons Limited has four operating divisions spread across four cities in Nigeria: Lagos, Kano, Gombe, and Enugu. These divisions are treated as investment centres for performance reporting purposes. The following information is available:

Particulars	Lagos	Kano	Gombe	Enugu
Divisional Investment (N)	10,000,000	4,000,000	3,000,000	7,000,000
Divisional Sales (N)	53,000,000	23,000,000	24,600,000	29,400,000
Divisional Variable Costs (N)	50,000,000	22,000,000	23,400,000	27,400,000
Specific Fixed Costs (N)	1,500,000	750,000	600,000	800,000

The company’s annual general fixed cost is N1,300,000, apportioned to divisions based on sales. The cost of capital for Ngerige and Sons Limited is 7.5%. Ignore taxation.

Required:

i. Evaluate the performance of the divisions using the following methods:

ROI method. (3 Marks)
Residual Income Method. (3 Marks)

ii. Re-evaluate the residual income situation for the company given an adjusted cost of capital of 10%. (3 Marks)

Answer

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Tags: Cost of Capital, Division Performance, Investment Centres, Profitability Ratios, Residual Income, ROI
Level: Level 2

Topic: Divisional Performance Measurement

PM – May 2017 – L2 – SA – Q6 – Standard Costing and Variance Analysis

Advise on optimal replacement timing for AL Limited's machine based on cost-benefit analysis.

Question

AL Limited, a manufacturing company based in Aba, produces a popular mortar coloring agent called Hadtone. Hadtone is packaged in five-litre cartons, sold at ₦300 each. Estimated maximum annual demand is 300,000 cartons, justifying one processing machine, replaced every three years though it has a four-year productive life.

Machine Details: Initial productive capacity aligns with maximum demand, decreasing by 15,000 units per annum. Maintenance costs in year one are ₦300,000, rising by ₦50,000 each subsequent year. Variable costs per carton (excluding maintenance) are ₦200.
Machine Depreciation: Straight-line method. Sale proceeds after one year are ₦8,000,000, reducing by ₦3,000,000 each following year.
Machine Cost Increase: Recent machine cost rise to ₦12,000,000 prompts reconsideration of replacement policy to optimize cash flow. Assume all costs/revenues except initial payment occur year-end; initial cost paid at purchase.

Requirements:

a. Calculate replacement frequency based on maximum capacity usage, including supporting calculations. Assume a 10% cost of capital. (12 Marks)

b. Itemize key assumptions made in the calculations. (3 Marks)

Answer

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Tags: Cash Flow, Cost of Capital, Depreciation, Replacement Analysis
Level: Level 2

Topic: Standard Costing and Variance Analysis
Series: MAY 2017

PM – May 2023 – L2 – SA – Q5 – Risk Assessment and Internal Control

Evaluate which project (A or B) the company should invest in, based on projected cash flows and cost of capital.

Question

A company is considering whether or not to invest in any of the two projects where the initial cash investment would be ₦13,000,000 for Project A and ₦14,000,000 for Project B. The project would have a five-year life, and the estimated annual cash flows are as follows:

Project A

Year	Cash inflows (₦)	Cash outflows (₦)
1	6,000,000	3,000,000
2	8,000,000	4,000,000
3	10,000,000	4,000,000
4	9,000,000	3,000,000
5	6,000,000	3,000,000
Total	39,000,000	17,000,000

Project B

Year	Cash inflows (₦)	Cash outflows (₦)
1	10,000,000	5,000,000
2	9,000,000	4,000,000
3	8,000,000	3,000,000
4	8,000,000	3,000,000
5	4,000,000	2,000,000
Total	39,000,000	17,000,000

The company cost of capital is 10%.

The estimates of cash outflows are considered fairly reliable. However, the estimates of cash inflows are much more uncertain. Several factors could make the annual cash flows higher or lower than expected.

Factor 1: There is a 20% probability that government measures to control the industry will reduce annual cash inflows by 25%.
Factor 2: There is a 30% probability that another competitor will also enter the market; this would reduce the estimated cash inflows by 10%.
Factor 3: There is a 40% probability that demand will be stronger than expected. The company would not be able to supply more products to the market, but it would be able to sell at higher prices and cash inflows would be 5% higher than estimated.

Required:

a. Calculate the expected net present value of the two projects. (10 Marks)
b. Which of the projects will be more profitable? (5 Marks)

Answer

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Tags: Cash Inflows, Cash Outflows, Cost of Capital, Investment decisions, Project A, Project B
Level: Level 2

Topic: Risk Assessment and Internal Control
Series: MAY 2023

PM – May 2024 – L2 – SC – Q5 – Divisional Performance Measurement

Calculation of transfer prices and performance appraisal in a holding company.

Question

Zona Tango (ZT) plc is a holding company with four divisions, including Alba and Beta Divisions. Alba Division produces a component that it sells externally, and can also transfer to other divisions within the group.

Beta Division uses the components from Alba Division as a raw material for its final product. The division can also obtain the components from external suppliers. The components, when obtained from Alba Division, undergo further processing at a cost of ₦4.50 per unit before they are sold to the external market.

The Board of Directors, in order to implement a new Appraisal Review, has set up a performance scheme for the divisional managers. A performance target for the next financial year has been set, and the following budgeted information relating to the two divisions has been prepared:

Beta Division has asked Alba Division to quote a transfer price for units of the components.

Required:
a. Calculate the transfer price per unit which Alba Division should quote to Beta Division in order that its budgeted residual income target will be achieved. (3 Marks)
b. Calculate the selling price per unit which Beta Division should quote to the external market in order that its budgeted residual income target will be achieved, based on the transfer price quotation. State clearly your assumptions. (3 Marks)
c. Explain why the transfer price calculated in (a) may lead to sub-optimal decision-making from the point of view of ZT plc, taken as a whole. (5 Marks)
d. In what circumstances will a negotiated transfer price be used instead of a market-based price? (4 Marks)

Answer

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Tags: Capital Employed, Cost of Capital, Divisional Performance, Residual Income, Transfer Pricing
Level: Level 2

Topic: Divisional Performance Measurement
Series: MAY 2024

BMF – May 2023 – L1 – SB – Q2 – Investment Decisions

Use the IRR method to evaluate two projects and recommend which one should be selected.

Question

Johnson and Jacob Limited is considering whether to invest in one of these two projects. The expected cash flows are as stated below:

Year	Project Blue (N’000)	Project Pink (N’000)
0	(33,000)	(30,000)
1	18,000	3,000
2	6,000	3,000
3	3,000	6,000
4	15,000	30,000

The company anticipates a cost of capital of 12%. Using the Internal Rate of Return (IRR) method of investment appraisal, which of the projects should be selected?

Answer

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Tags: Cost of Capital, Decision Making, Investment Appraisal, IRR
Level: Level 1

Topic: Investment Decisions
Series: MAY 2023

BMF – May 2023 – L1 – SA – Q9 – Investment Decisions

Calculate the NPV of a project with given cash inflows over a 3-year period and a 10% cost of capital.

Question

A firm plans to invest N20 million in a project with a life span of 3 years.

Projected cash inflows are as follows:

Years	Cash Flows (N Million)
1	8
2	10
3	8

If the cost of capital is 10%, calculate the NPV of the project.

A. N1.34 million
B. N1.44 million
C. N1.54 million
D. N1.64 million
E. N1.74 million

Answer

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Tags: Capital Budgeting, Cash Flow, Cost of Capital, Net Present Value
Level: Level 1

Topic: Investment Decisions
Series: MAY 2023

AFM – May 2017 – L3 – Q2b – Sources of finance and cost of capital

Calculate the cost of capital for Oheneba Limited with two different capital structures.

Question

Oheneba Limited is considering the acquisition of a concession in the Brong Ahafo region to enable it to start a quarry business. The average industry beta is 1.6 with an equity-to-debt ratio of 2:1.

The following information was extracted from the books of Oheneba Limited:

Income Statement

You are also informed that the long-term debt of the company is considered risk-free with a gross redemption yield of 10% and the beta coefficient of the company’s equity is 1.2, while the average return on the stock market is 15%.

Required:
i) Determine the cost of capital to apply for the appraisal of the quarry if Oheneba Limited will maintain its capital structure after the implementation of the quarry project. (5 marks)
ii) Determine the cost of capital to apply if the company will change its capital structure to 20% debt and 80% equity. (3 marks)

Answer

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Tags: Beta, Cost of Capital, Debt-to-Equity Ratio, Quarry project, Risk-free rate, WACC
Level: Level 3

Topic: Sources of finance and cost of capital
Series: MAY 2017

AFM – Nov 2017 – L3 – Q2 – Sources of finance and cost of capital

Calculation of the cost of capital using the WACC and CAPM methods for a company and discussing when to use the cost of equity or WACC for discounting.

Question

Animal Farm Product Ltd, (AFP), a manufacturer of veterinary medicines for farm animals, wishes to estimate its current cost of capital.

The following figures have been extracted from their most recent accounts:

Other relevant data:

The current market value of AFP’s ordinary shares is GH¢12.50 per share cum-dividend. AFP’s beta is 1.4, the risk-free rate is 3%, and the return on the SEC index (the market proxy) is 8%. An annual dividend of GH¢800,000 is due for payment shortly.
The 8% debentures are irredeemable and are trading at a current market value of GH¢106.00, a GH¢6.00 premium over their issue price of GH¢100.00. Semi-annual interest of GH¢4 million has just been paid on the debentures.
The 6% preference shares are trading at a current market value of GH¢6.00, a GH¢1 above their issue price of GH¢5.00. Interest has just been paid on these preference shares.
There have been no issues or redemptions of ordinary shares or debentures during the past five years, and the corporation tax rate remains at 12.5%. Assume that tax relief on the debenture interest arises at the same time as the interest payment.

Required:

a) Calculate the cost of capital that AFP should use as a discount rate when appraising new marginal investment opportunities. (11 marks)

b) Explain when firms should discount projects using:

The cost of equity;
The WACC instead; and
When should they use neither? You may use the information and your results in part (a) as examples. (6 marks)

c) Discuss what type of covenants might be attached to bonds. (3 marks)

Answer

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Tags: Bonds, CAPM, Cost of Capital, Preference shares, WACC
Level: Level 3

Topic: Sources of finance and cost of capital
Series: NOV 2017

AFM – Nov 2018 – L3 – Q3b -Valuation and use of free cash flows

Estimate the value of the firm and its equity using the FCFF and FCFE valuation approaches and calculate the value per share.

Question

DoGood Ltd is evaluating Phinex Ltd using the Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) valuation approaches.

DoGood Ltd has gathered the following information (in current Ghana Cedis terms):

Phinex Ltd has net income of GH¢250 million, depreciation of GH¢90 million, capital expenditures of GH¢170 million, and an increase in working capital of GH¢40 million.
Phinex Ltd will finance 40% of the increase in net fixed assets (capital expenditures less depreciation) and 40% of the increase in working capital with debt financing.
Interest expenses are GH¢150 million. The current market value of Phinex’s outstanding debt is GH¢1,800 million.
FCFF is expected to grow at 6.0% indefinitely, and FCFE is expected to grow at 7.0%.
The tax rate is 30%.
Phinex Ltd is financed with 40% debt and 60% equity. The before-tax cost of debt is 9% and the before-tax cost of equity is 13%.
Phinex Ltd has 10 million outstanding shares.

Required:
i) Using the FCFF valuation approach, estimate the total value of the firm, the total market value of equity, and the value per share.
(6 marks)

ii) Using the FCFE valuation approach, estimate the total market value of equity and the value per share.
(6 marks)

Answer

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Tags: Cost of Capital, FCFE, FCFF, Free Cash Flow, Valuation, Value per Share
Level: Level 3

Topic: Valuation and use of free cash flows
Series: NOV 2018

AFM – Nov 2018 – L3 – Q1a – Discounted cash flow techniques

Evaluating an irrigation project using the Adjusted Present Value (APV) method, incorporating debt financing, government subsidy, and project cash flows.

Question

One-Village Water Resources Ltd (One-Village) is considering a damming and irrigation project that will supply water to tomato farms around the Oti River. One-Village plans to commence the construction and installation phase of the project immediately and complete it in three years. One-Village will invest GH¢3 million in new plants and equipment now. Mobilisation to the project site will cost GH¢0.5 million now. Development costs are expected to be GH¢3 million in the first year, GH¢4 million in the second year, and GH¢2 million in the third year.

The commercial phase of the project will commence in the fourth year and run indefinitely. The project will generate after-tax net cash flows of GH¢6 million in the fourth year and GH¢8 million in the fifth year. Beyond the fifth year, cash flows will grow by 5% every year to perpetuity.

One-Village has 10 million shares outstanding, which are currently trading at GH¢3.5 each. The total value of its debt stock is GH¢20 million. One-Village plans to finance the investment requirements of the construction and installation phase of the project with new debt. Its borrowing cost is 20%, while its cost of equity is 25%. The Government of Ghana is promoting large-scale farming and is willing to give a subsidised loan of up to GH¢10 million at 15% annual interest. One-Village plans to take the maximum subsidised loan from the Government of Ghana and finance the balance with a bank loan. Issue costs, which are tax-deductible, are expected to be GH¢0.6 million. Both loans will be repaid in five years. One-Village falls into the 22% corporate income tax category. The risk-free interest rate is 14%, and the return on the market portfolio is 18%.

Required:
Evaluate the project using the adjusted present value (APV) technique and recommend whether it should be implemented or not. (12 marks)

Answer

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Tags: APV, Cost of Capital, Government Subsidy, NPV, Project Finance
Level: Level 3

Topic: Discounted cash flow techniques
Series: NOV 2018

AFM – May 2016 – L3 – Q2a – Discounted cash flow techniques, Valuation and use of free cash flows, Theories of capital structure

Compute NPV for two investment projects using WACC and CAPM, and provide recommendations based on risk analysis.

Question

a) Joebel Limited is a diversified company operating in different industries on the African Continent. The shares of the company are widely traded on the stock exchange and currently have a market price of GH¢3.20 per share. The company’s dividend payment over the last five years is as follows:

Year	Dividend Per Share (DPS) (GH¢)
2015	0.35
2014	0.32
2013	0.30
2012	0.29
2011	0.28

The Board of Directors of Joebel Limited is considering two main investment opportunities: one in the Oil and Gas sector and the other in the Hotel and Tourism sector. Both projects have short lives and their associated cash flows are as follows:

Year	Oil & Gas (GH¢’000)	Hotel & Tourism (GH¢’000)
1	85	180
2	175	195
3	160	150

The investment in Oil and Gas would cost GH¢400,000, while the investment in Hotel and Tourism would cost GH¢405,000. The Management of the Company has identified the industry beta for Oil and Gas as 1.2 and for Hotel and Tourism as 1.6. However, Joebel Limited’s company beta is 1.5. The average return on companies listed on the stock exchange is 25%, and the yield on Treasury bills is 20%.

Required:
i) Compute the Net Present Values (NPV) of both projects using the company’s weighted average cost of capital as the discount rate. (5 marks)
ii) Compute the NPV using a discount rate that takes into account the risk associated with the individual projects. (5 marks)
iii) Advise Management regarding the suitability and acceptability of the projects. (1 mark)

Answer

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Tags: Cost of Capital, Hotel & Tourism, Investment Appraisal, Net Present Value (NPV), Oil & Gas, Risk
Level: Level 3

Topic: Discounted cash flow techniques, Valuation and use of free cash flows
Series: MAY 2016

MA – Nov 2020 – L2 – Q4a – Discounted Cash Flow

Calculate the cost of capital to break-even for a van investment over five years and discuss the advantages and disadvantages of the payback method.

Question

a) Jayjay & Co is a medium-sized company that is engaged in delivery services. As a result of the recent increase in the demand for its services, the Managing Director (MD) is planning to acquire a delivery van at the cost of GH¢85,000. The expected net cash flow per year is as follows:

Year	Net Cash Flow (GH¢)
1	25,000
2	28,000
3	39,000
4	34,000
5	24,000

The Sales Manager has indicated to the MD that the company will recoup its investment in less than four years, and for that reason, it’s a good investment. The Management Accountant, however, has drawn the MD’s attention to the fact that the Sales Manager has not factored in the time value of money and the cost of capital into his analysis.

Required:

i) Calculate the cost of capital that, when used, will make the investment break-even when the useful life of the van is five years with a residual value of GH¢8,500.
ii) Explain TWO (2) advantages and TWO (2) disadvantages of the payback method of investment appraisal and show how it compares to the discounted cash flow method.

Answer

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Tags: Capital Budgeting, Cost of Capital, Investment Appraisal, Payback Method
Level: Level 2

Topic: Discounted cash flow
Series: NOV 2020

MA – April 2022 – L2 – Q4a – Discounted cash flow

Evaluate the acceptability of a project using the Net Present Value (NPV) method considering cash flows and cost of capital.

Question

Phil Company is considering replacing its existing machine on the introduction of a new product. The existing machine would be sold for GH¢2 million and replaced with a new machine at the beginning of the year at the cost of GH¢16 million. This new machine would be sold at the end of year 4 for GH¢1 million.

A market research recently carried out at a cost of GH¢1.5 million indicates a unit selling price of GH¢300 in year 1, rising by 10% per annum. Sales volume for the four-year life of the project has been estimated as follows:

Year	Units
1	60,000
2	85,000
3	85,000
4	80,000

Possible unit variable costs are as follows:

Probability	GH¢
0.4	240
0.6	260

Incremental fixed cost as a result of the project is GH¢15 per unit plus GH¢1,000,000 per annum staff cost.

The introduction of the new product is expected to reduce the market demand for an existing product by 5,000 units per annum. The existing product has a unit contribution of GH¢75.

Other annual fixed costs associated with the new product include the following:

Amortization of goodwill: GH¢50,000
Depreciation: GH¢250,000

Phil Company’s cost of capital is 12%.

Required:

Evaluate the acceptability of the project.

Answer

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Tags: Cash Flows, Cost of Capital, Net Present Value, Project evaluation
Level: Level 2

Topic: Discounted cash flow
Series: APR 2023

MA – Nov 2016 – L2 – Q5a – Discounted cash flow

Calculate the NPV break-even point under different cost of capital scenarios and determine the project's duration based on given cash inflows.

Question

DDB Limited has decided to set up a factory to process groundnuts into oil. The feasibility studies cost them GH¢35,000. The consultants have advised that the initial outlay will be GH¢250,000; however, they were unable to estimate the cash inflow due to the uncertain economic environment.

Required:
Using NPV as an appraisal technique, you are required to calculate:

i) The constant cash inflow needed to break even if the cost of capital is 15% and the project is to last for 10 years.

(4 marks)

ii) By how much should the cash inflow increase to break even if the cost of capital is increased to 20%. (4 marks)

iii) If the cash inflow is GH¢45,000, for how long should the project run to break even if the cost of capital is 15%.

(4 marks)

Answer

Find Related Questions by Tags, levels, etc.

Tags: Break-even Analysis, Cost of Capital, Discounted Cash Flow, NPV, Project evaluation
Level: Level 2

Topic: Discounted cash flow
Series: NOV 2016

Question Tag: Cost of Capital

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