- 20 Marks
Question
a) Ntam Ghana Ltd has identified an opportunity in the Cement Industry in Ghana and decided to set up a plant to produce cement in Ghana under the brand name “Kong” in 50kg per bag. This new product has performed very well in the marketing trials carried out by the Research and Development division of the company.
The following information regarding the investment has been prepared by the Finance Manager:
- Initial Investment (Plant Cost) = GH¢50 million
- Working capital (At the beginning) = GH¢5 million
- Selling price per bag (current price terms) = GH¢50
- Variable cost per bag (current price terms) = GH¢25
- Fixed operating cost per year (current year terms) = GH¢5 million
- Annual Demand (current year terms) = 500,000 bags
The table below represents the forecast increases for the next 5 years:
| Year | Selling Price | Variable Cost | Fixed Operating Cost | Annual Demand |
|---|---|---|---|---|
| 1 | 15% | 10% | 10% | 10% |
| 2 | 18% | 15% | 15% | 14% |
| 3 | 20% | 15% | 15% | 16% |
| 4 | 15% | 12% | 20% | 15% |
| 5 | 17% | 13% | 18% | 14% |
The initial investment plant is depreciated at 20% per annum on a straight-line basis with a residual value of GH¢5 million at the end of the period. Prior discussions with Ghana Revenue Authority confirm approval for an allowable capital allowance rate on the above investment at 20% per annum. The company uses 22% as its internal cost of capital, and the Corporate tax rate for the company is 25%.
Required:
Compute the Net Present Value (NPV) and advise whether the investment should be undertaken. (15 marks)
b) Investors in the Financial Markets have the option of trading on the primary market or secondary market or both. As a professional investor in the Financial Markets, you are required to:
i) Distinguish between the Primary market and Secondary market. (2 marks)
ii) State THREE (3) reasons the secondary market is more important to investors. (3 marks)
Answer
a) Net Present Value (NPV) Calculation and Advice:
- Forecasted Cash Flows:
The initial investment is depreciated 20% per annum and on straight line basis with
a scrap value 5 million and the tax rate for Allowable capital allowance is 25%.
- Present Value of Cash Flows:
NPV = (55,000,000) + 8,606,850 + 9,768,555 + 14,246,064 + 13,040,273 + 18,476,514 = GH¢9,138,256
Decision:
The NPV for the project is positive and therefore the project should be undertaken. (15 marks)
b) Primary Market vs. Secondary Market:
i) Distinction Between Primary Market and Secondary Market:
- Primary Market: The financial market where new securities or financial instruments are issued and sold to investors for the first time. Companies raise fresh capital by issuing new shares or bonds in this market.
- Secondary Market: The financial market where existing securities or financial instruments are traded among investors. No new capital is raised by the issuing company as the transactions are between investors.
(2 marks)
ii) Three Reasons Why the Secondary Market is More Important to Investors:
- Liquidity: Secondary markets provide liquidity to investors by allowing them to buy and sell securities easily.
- Price Discovery: Through the continuous trading in the secondary market, the fair value of securities is established based on supply and demand.
- Benchmark for Valuation: The prices in the secondary market serve as a benchmark for the valuation of securities and new issues in the primary market.
(3 marks)
- Tags: Capital Allowance, Cement industry, Fixed Costs, Investment Appraisal, NPV, Working Capital
- Level: Level 2
- Topic: Discounted cash flow, Introduction to Investment Appraisal
- Series: JULY 2023
- Uploader: Theophilus