Menu
- 15 Marks
Question
The following mutually exclusive investment opportunities are being proposed to Kwame, who wants reliable cash receipts on an annual basis:
Proposal A:
Purchase of a commercial vehicle at the cost of GH¢90,000 that will generate weekly sales of GH¢800. The owner will incur the following annual expenses on the vehicle:
| Expenses | GH¢ |
|---|---|
| Insurance | 1,200 |
| Tyres | 10,400 |
| Roadworthy | 1,400 |
| Routine maintenance | 9,000 |
Note: Assume 52 weeks in a year.
Proposal B:
The repair of an unoccupied two-bedroom flat at the cost of GH¢90,000. The flat was bought by Kwame for GH¢650,000 three years ago. The monthly rental will be GH¢1,450 subject to 8% rent tax. The owner will also pay property tax of GH¢1,200 per year.
Required:
i) Advise Kwame which of the proposals is acceptable using the payback period method of investment appraisal. (8 marks)
ii) Explain TWO (2) factors that can affect the reliability of the cash flow of the transport business. (2 marks)
iii) State TWO (2) qualitative factors that may influence the decision to opt for proposal B. (2 marks)
iv) Explain TWO (2) reasons the NPV may be a better appraisal technique than the payback period. (3 marks)
Answer
i) Payback Period Calculation for Proposal A (Transport):
| Receipts | GH¢ |
|---|---|
| Weekly sales (GH¢800 × 52 weeks) | 41,600 |
| Less: Direct expenses | (22,000) |
| Net cash inflow | 19,600 |
Payback Period for Proposal A = GH¢90,000 ÷ GH¢19,600 = 4.59 years
ii) Payback Period Calculation for Proposal B (Rental):
| Receipts | GH¢ |
|---|---|
| Monthly rent (GH¢1,450 × 12 months) | 17,400 |
| Less: Rent tax (8%) | (1,392) |
| Net rental income | 16,008 |
| Less: Property tax | (1,200) |
| Net cash inflow | 14,808 |
Payback Period for Proposal B = GH¢90,000 ÷ GH¢14,808 = 6.08 years
Advice: Based on the payback period method, Proposal A (Transport) is preferable with a payback period of 4.59 years compared to 6.08 years for Proposal B (Rental).
(Marks are evenly spread using ticks = 8 marks)
ii) Factors Affecting Reliability of Cash Flow in Transport Business:
- Fluctuations in Passenger Demand: Changes in customer demand due to external factors like competition, weather, or economic downturns can affect revenue.
- Maintenance and Fuel Costs: Any increase in direct operational costs, such as fuel prices or unexpected repairs, can reduce net cash inflows and affect the accuracy of the cash flow projections.
(2 marks)
iii) Qualitative Factors Influencing the Decision to Opt for Proposal B:
- Appreciation of Property Value: The property may increase in value over time, providing long-term capital gains beyond rental income.
- Risk Exposure: The rental business may have a lower risk profile compared to the transport business, which is exposed to higher operational risks like accidents or breakdowns.
(2 marks)
iv) Why NPV May Be Preferred Over Payback Period:
- Time Value of Money: NPV takes into account the time value of money, discounting future cash flows, whereas the payback period simply considers the time required to recover the initial investment.
- Comprehensive Evaluation: NPV considers all cash flows over the project’s life, ensuring that projects with longer-term profitability are not rejected solely because of a longer payback period.
- Tags: Cash Flow, Investment Appraisal, Payback Period, Rental Business, Transport Business
- Level: Level 2
- Topic: Decision making techniques
- Series: MAR 2024
- Uploader: Joseph