STAR FINANCIAL CONSULTANTS CPA REVIEW CLASSES
QUESTIONS ON CAPITAL BUDGETING / INVESTMENT APPRAISAL
QUESTION 1
Melanie Co is considering the acquisition of a new machine with an operating life of three years. The new
machine could be leased for three payments of $55,000, payable annually in advance.
Alternatively, the machine could be purchased for $160,000 using a bank loan at a cost of 8% per year. If the
machine is purchased, Melanie Co will incur maintenance costs of $8,000 per year, payable at the end of
each year of operation. The machine would have a residual value of $40,000 at the end of its three‐year life.
Melanie Co’s production manager estimates that if maintenance routines were upgraded, the new machine
could be operated for a period of four years with maintenance costs increasing to $12,000 per year, payable
at the end of each year of operation. If operated for four years, the machine’s residual value would fall to
$11,000. Taxation should be ignored.
Required:
(a)
(i) Assuming that the new machine is operated for a three‐year period, evaluate whether Melanie
Co should use leasing or borrowing as a source of finance.
(6 marks)
(ii) Using a discount rate of 10%, calculate the equivalent annual cost of purchasing and operating
the machine for both three years and four years, and recommend which replacement interval
should be adopted.
(6 marks)
(b) Critically discuss FOUR reasons why NPV is regarded as superior to IRR as an investment appraisal
technique.
(8 marks)
(Total: 20 marks)
FINANCIAL MANAGEMENT (B1)
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INTERMEDIATE LEVEL
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STAR FINANCIAL CONSULTANTS CPA REVIEW CLASSES
QUESTION 2
Pinks Co is a large company listed on a major stock exchange. In recent years, the board of Pinks Co has
been criticised for weak corporate governance and two of the company’s nonexecutive directors have just
resigned. A recent story in the financial media has criticized the performance of Pinks Co and claims that the
company is failing to satisfy the objectives of its key stakeholders.
Pinks Co is appraising an investment project which it hopes will boost its performance. The project will cost
$20m, payable in full at the start of the first year of operation. The project life is expected to be four years.
Forecast sales volumes, selling price, variable cost and fixed costs are as follows:
Year
1
2
3
4
$000
$000
$000
$000
Sales (units/year)
300,000
410,000
525,000
220,000
Selling price ($/unit)
125
130
140
120
Variable cost ($/unit)
71
71
71
71
Fixed costs ($000/year)
3,000
3,100
3,200
3,000
Selling price and cost information are in current price terms, before applying selling price inflation of 5% per
year, variable cost inflation of 3.5% per year and fixed cost inflation of 6% per year.
Pinks Co pays corporation tax of 26%, with the tax liability being settled in the year in which it arises. The
company can claim tax‐allowable depreciation on the full initial investment of $20m on a 25% reducing
balance basis. The investment project is expected to have zero residual value at the end of four years.
Pinks Co has a nominal after‐tax cost of capital of 12% and a real after‐tax cost of capital of 8%. The general
rate of inflation is expected to be 3.7% per year for the foreseeable future.
Required:
(a)
(i) Calculate the nominal net present value of Pinks Co’s investment project.
(8 marks)
(ii) Calculate the real net present value of Pinks Co’s investment project andcomment on your
findings.
(4 marks)
(b) Discuss FOUR ways to encourage managers to achieve stakeholder objectives.
(8 marks)
(Total: 20 marks)
FINANCIAL MANAGEMENT (B1)
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INTERMEDIATE LEVEL
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STAR FINANCIAL CONSULTANTS CPA REVIEW CLASSES
QUESTION 3
Dink Co is a small company that is finding it difficult to raise funds to acquire a new machine costing $750,000.
Dink Co would ideally like a four‐year loan for the full purchase price at a before‐tax interest rate of 8.6% per
year. The machine would have an expected life of four years. At the end of this period the machine would
have a residual value of $50,000. Tax‐allowable servicing costs for the machine would be $23,000 per year.
Tax‐allowable depreciation on the full purchase price would be available on a 25% reducing balance basis.
A leasing company has offered a contract whereby Dink Co could have use of the new machine for four years
in exchange for an annual lease rental payment of $200,000, payable at the start of each year. The contract
states that the leasing company would undertake maintenance of the machine at no additional cost to Dink
Co. At the end of four years the leasing company would remove the machine from the manufacturing facility
of Dink Co.
Dink Co pays corporation tax of 30% one year in arrears.
Required:
(a) For the new machine:
(i) Calculate the present value of the cost of borrowing to buy.
(6 marks)
(ii) Calculate the present value of the cost of leasing.
(3 marks)
(iii) Recommend which option is more attractive in financial terms to Dink Co.
(1 mark)
(b)
(i) Discuss general reasons why investment capital may be rationed.
(6 marks)
(ii) Discuss ways in which the external capital rationing experienced by Dink Co might be
overcome.
(4 marks)
(Total: 20 marks)
FINANCIAL MANAGEMENT (B1)
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INTERMEDIATE LEVEL
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