Capital Selection Techniques-Illustrations
Capital Selection Techniques-Illustrations
Capital Selection Techniques-Illustrations
CLASS ILLUSTRATIONS:
Illustration.1
KCCA has approached the African Development Bank to fund this project with
a five-year loan with a cost of 15% per annum. This project is expected to cost
US $ 100,000,000. When completed, the Bypass will generate net cash inflows
from the user fees as follows:
SOLUTION: 1
Cumulative Cash
Year Cash Inflow inflow
1 20,000,000 20,000,000
2 25,000,000 45,000,000
3 30,000,000 75,000,000
4 50,000,000 125,000,000
5 60,000,000 185,000,000
Advise:
Advise:
Illustration. 2
Devine Enterprises has identified two possible areas of investment, a printer
and a super market with defined life spans. The two projects are mutually
exclusive. They are expected to generate the following net cash flows.
Period/Item Supermarket Printery
Initial cost 80,000,000 50,000,000
Cash inflows
Year 1 15,000,000 15,000,000
Year 2 20,000,000 15,000,000
Year 3 25,000,000 15,000,000
Year 4 30,000,000 15,000,000
Year 5 30,000,000 15,000,000
Required:
a) Advise the management of the company on the best project to invest using:
i. Net present value method (NPV) at a cost of capital is 13%.
ii. Using the payback period method (non-discounted).
SOLUTION:2
Note: 20,000,000 is the difference between the cumulative 60,000,000 and the
Initial investment of 80,000,000; and 30,000,000 is the next year cash flow.
Advise: The Printery has a shorter PBP of 3 years and 4 months compared to
the supermarket with 3 years and 8 months. So according to the decision
criteria for PBP which prefers a project with a shorter PBP, THE Printery
should be chosen for investment.
PRACTICE QUESTIONS:
Question 1.
(a) Briefly discuss the features and types of capital investment
projects
At the end of year 4, the machine will require a capital overhaul costing
US $ 10,000 to maintain its operating capacity to be able to
generate cash flows projected above.
The machine is expected to be sold off at the end of year 7 to
realize US $ 25,000.
Required:
(i) Using the Net Present Value technique advise the company
management accordingly.
(ii) Using the Internal Rate of Return and advise the company
management accordingly.
Question 2
MACHINERY A B C
Initial investment 80,000 30,000 50,000
Cash inflows
Year 1 24,000 10,000 0
Year 2 24,000 10,000 0
Year 3 24,000 10,000 30,000
Year 4 24,000 10,000 30,000
Year 5 24,000 10,000 30,000
At the end of the 5th year the equipment will be sold off and will
realize cash as follows: Machinery A US $ 20,000, machinery B US
$ 8,000 and machinery C US $ 15,000.
Required:
Question 3
Required:
Using each of the following techniques advise UTODA Ltd whether they should
undertake the project.
Question 4
The Estates Department of the University has estimated that renovating all the
University Halls of residence will cost the University US $ 25,000,000.
Bids have also been obtained from prospective Private Operators of these
facilities and the best evaluated bidder is proposing to pay the University US $
3,000,000 per annum.
When the funding is obtained and the Halls of Residence are renovated, the
University will sign a ten-year contract with the best evaluated private
operator.
Required:
(ii) Using the Net Present Value technique, advise the University whether or
not the project should be undertaken.
Question 5
a) Briefly describe the logical process of capital budgeting.
b) What are the key features of investment projects?
c) Kampala Capital City Authority (KCCA) is considering the construction of
Southern Bypass to ease the traffic jam in the city. When the Bypass is
completed it will be a commercial express highway where the user
pays a service fee for using the facility.
KCCA has approached the African Development Bank to fund this project with
a ten-year loan with a cost of 10% per annum. This project is expected to cost
US $ 250,000,000. When completed, the Bypass will generate net cash inflows
from the user fees as follows:
Net cash
Year inflows in US
$
Year 1 10,000,000
Year 2 25,000,000
Year 3 40,000,000
Year 4 50,000,000
Year 5 75,000,000
Year 6 75,000,000
Year 7 80,000,000
Year 8 80,000,000
Year 9 80,000,000
Year 10 80,000,000
Required:
INTEREST RATE
Year 1% 2% 4% 6% 8% 10% 12% 14% 15% 16% 18% 20% 25%
1 0.990 0.980 0.962 0.943 0.926 0.909 0.893 0.877 0.870 0.862 0.847 0.833 0.800
2 0.980 0.961 0.925 0.890 0.857 0.826 0.797 0.769 0.756 0.743 0.718 0.694 0.640
3 0.971 0.942 0.889 0.840 0.794 0.751 0.712 0.675 0.658 0.641 0.609 0.579 0.512
4 0.961 0.924 0.855 0.792 0.735 0.683 0.636 0.592 0.572 0.552 0.516 0.482 0.410
5 0.951 0.906 0.822 0.747 0.681 0.621 0.567 0.519 0.497 0.476 0.437 0.402 0.328
6 0.942 0.888 0.790 0.705 0.630 0.564 0.507 0.456 0.432 0.410 0.370 0.335 0.262
7 0.933 0.871 0.760 0.665 0.583 0.513 0.452 0.400 0.376 0.354 0.314 0.279 0.210
8 0.923 0.853 0.731 0.627 0.540 0.467 0.404 0.351 0.327 0.305 0.266 0.233 0.168
9 0.914 0.837 0.703 0.592 0.500 0.424 0.361 0.308 0.284 0.263 0.225 0.194 0.134
10 0.905 0.820 0.676 0.558 0.463 0.386 0.322 0.270 0.247 0.227 0.191 0.162 0.107
11 0.896 0.804 0.650 0.527 0.429 0.350 0.287 0.237 0.215 0.195 0.162 0.135 0.086
12 0.887 0.788 0.625 0.497 0.397 0.319 0.257 0.208 0.187 0.168 0.137 0.112 0.069
13 0.879 0.773 0.601 0.469 0.368 0.290 0.229 0.182 0.163 0.145 0.116 0.093 0.055
14 0.870 0.758 0.577 0.442 0.340 0.263 0.205 0.160 0.141 0.125 0.099 0.078 0.044
15 0.861 0.743 0.555 0.417 0.315 0.239 0.183 0.140 0.123 0.108 0.084 0.065 0.035