a) Payback method refers to the period of time it takes for the cash flows to cover the initial cost of investment or recoup the initial cost of investment. The period is usually calculated in years.
Required:
Identify TWO advantages and TWO disadvantages of using the payback method in investment appraisal.
(4 marks)
b) DÉCOR Ltd is analyzing the purchase of a new machine to produce product Z. The machine is expected to cost GH¢2,000,000. Production and sales of product Z are forecast as follows:
| Year |
1 |
2 |
3 |
4 |
| Production & Sales (units/year) |
70,000 |
106,000 |
150,000 |
72,000 |
The current selling price is GH¢30 per unit and is expected to increase by 5% a year. The current variable cost is GH¢18 per unit and is expected to increase by 6% per year. Fixed costs will remain the same, but an increase in working capital is required. Analysis of historical data of the levels of working capital of product Z indicates that, at the start of each year, investment in working capital will need to be 10% of sales revenue of that year.
The company pays tax at 25% per year in the year in which taxable profit occurs. The tax liability is reduced by the capital allowance on the machinery, and DÉCOR Ltd can claim on a straight-line basis over the four-year life of the proposed investment (capital allowance rate of 25% per annum). The new machine will have zero scrap value at the end of the four years. The cost of capital is 15% per year.
Required:
Calculate the Net Present Value (NPV) of the proposed investment and advise whether the proposed investment should be undertaken.
(11 marks)
c) An American company sells goods to a Ghanaian buyer for US$280,000 when the exchange rate is $1 = GH¢4.20. The Ghanaian buyer is allowed three months’ credit, and when the American company eventually receives the US dollars three months later and exchanges them for dollars, the exchange rate has moved to $1 = GH¢4.60.
Required:
i) What was the foreign exchange loss to the Ghanaian buyer?
(3 marks)
ii) Explain currency risk in relation to the above.
(2 marks)
iii) Explain transaction risk in relation to the above.
(2 marks)
iv) What will be the effect of the above on the company’s trading profits?
(3 marks)
