Question Tag: Project evaluation

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  • 15 Marks

MA – Dec 2023 – L2 – Q4a – Discounted Cash Flow

This question involves calculating the NPV for three projects being considered by Kanfa Ltd and recommending the best project based on financial grounds.

Kanfa Ltd received GH¢50 million as compensation from Ghana Highways Authority (GHA) when one of its properties was destroyed to pave way for the Accra–Kumasi highway construction. Management of Kanfa Ltd has decided to invest the amount received in one of three capital investment opportunities identified.

Project A:

This is a long-term project, which would run for 20 years and will require an immediate outlay of GH¢50 million and net annual cash profits as follows:

  • 1st to 5th years: GH¢2 million
  • 6th to 10th years: GH¢8 million
  • 11th to 15th years: GH¢15 million
  • 16th to 20th years: GH¢5 million

At the end of the 20th year, the project would be decommissioned at a cost of GH¢2 million.

Project B:

Kanfa Ltd is considering opening a Tourist Attraction Centre in Cape Coast, with an initial capital investment of GH¢50 million. It will operate for five years and be sold at an estimated price of GH¢5 million. The market research survey estimates the following visitor numbers and probabilities:

  • 800,000 visitors (30%)
  • 600,000 visitors (50%)
  • 400,000 visitors (20%)

Entrance fee: GH¢40 per visitor, and each visitor is expected to spend GH¢15 on souvenirs and GH¢5 on refreshments. Variable costs per visitor: GH¢25 (including souvenirs and refreshments). Maintenance costs: GH¢2 million per annum.

Project C:

This project involves a current outlay of GH¢50 million on equipment and GH¢15 million on working capital immediately. The working capital will increase to GH¢21 million in year one. Net annual cash profits: GH¢18 million for six years. The capital equipment can be sold for GH¢5 million at the end of the project.

Other information:

  • The company’s cost of capital is 12% for the three projects.
  • Ignore taxation and inflation.

Required:
Calculate the Net Present Value (NPV) of each project and recommend which project the company should undertake on financial grounds.

NPV Calculation for Project A:

Year Net Cash Flow (GH¢000) Discount Factor (12%) Present Value (GH¢000)
0 (50,000) 1.000 (50,000)
1-5 2,000 3.605 7,210
6-10 8,000 2.045 16,360
11-15 15,000 1.161 17,415
16-20 5,000 0.658 3,290
20 Decommissioning cost (2,000) 0.104 (208)
NPV (5,933)

NPV Calculation for Project B:

  • Weighted Average Visitors = (800,000 x 0.3) + (600,000 x 0.5) + (400,000 x 0.2) = 620,000 visitors
  • Contribution per Visitor = Entrance fee (GH¢40) + Souvenirs (GH¢15) + Refreshments (GH¢5) – Variable cost (GH¢25) = GH¢35
Year Net Cash Flow (GH¢000) Discount Factor (12%) Present Value (GH¢000)
0 (50,000) 1.000 (50,000)
1-5 21,700 3.605 71,018.5
5 Sale value 5,000 0.567 2,835
NPV 23,853.5

NPV Calculation for Project C:

Year Net Cash Flow (GH¢000) Discount Factor (12%) Present Value (GH¢000)
0 (50,000) 1.000 (50,000)
0 Working Capital (15,000) 1.000 (15,000)
1 Additional Working Capital (6,000) 0.893 (5,358)
1-6 18,000 4.111 73,998
6 Release of Working Capital 21,000 0.507 10,647
7 Sale value 5,000 0.452 2,260
NPV 16,547

Recommendation:
Based purely on financial grounds, Kanfa Ltd should invest in Project B since it gives the highest NPV of GH¢23,853,500.

  • 12 Marks

MA – Nov 2021 – L2 – Q4a – Discounted Cash Flow

Calculate and evaluate the payback period for the Ohenewa project based on provided cash flows.

a) Bee Ltd manufactures high-quality mobile phones for its local market. Due to less competition, Bee Ltd sales have grown significantly over the past few years and are expected to grow. Bee Ltd is planning to launch a new model, ‘Ohenewa’.

The company has already spent GH¢1 million on Research and Development and will require a further investment of GH¢5.5 million in production equipment. This cost excludes the GH¢1.1 million installation fee. The project has a life span of five years. In the end, the equipment will have a residual value of GH¢0.6 million. Sales and production of Ohenewa over its lifecycle are expected to be:

Year Units
1 6,500
2 7,500
3 8,000
4 7,800
5 7,000

The selling price in Year 1 and Year 2 will be GH¢750 per unit. However, the selling price will be reduced to GH¢600 per unit in Year 3 and will remain at this level for the remainder of the project. The variable cost as a percentage of sales is 55% over the entire product lifecycle. The fixed overhead, including depreciation cost expected to be incurred directly due to increasing the production capacity, is GH¢2 million per annum.

Other information:

  • A cost of capital of 12% per annum is used to evaluate projects of this type.
  • Bee Ltd has a history of accepting similar projects which pay back within three years.
  • Ignore inflation and taxation.

Required:
i) Calculate the Payback Period for the Ohenewa project. (10 marks)
ii) Evaluate the acceptability of the project based on the calculation in i) above. (2 marks)

i) Payback Period Calculation:

Year Net Cash Flow (GH¢) Cumulative Cash Flow (GH¢)
0 (6,600,000) (6,600,000)
1 1,393,750 (5,206,250)
2 1,731,250 (3,475,000)
3 1,360,000 (2,115,000)
4 1,306,000 (809,000)
5 1,690,000 881,000

Payback Period = 4 years + 809,0001,690,000×12\frac{809,000}{1,690,000} \times 12 months = 4 years 5 months
(10 marks)

ii) Evaluation:
The project should be rejected as the payback period of 4 years 5 months is more than the company’s acceptable payback period of three years. (2 marks)

Workings:

  • Annual Depreciation:

Depreciation=6,600,000−600,0005=GH¢1,200,000\text{Depreciation} = \frac{6,600,000 – 600,000}{5} = GH¢1,200,000

  • Net Cash Flows:
    • Year 1: (6,500×GH¢750)×0.45−GH¢800,000=GH¢1,393,750(6,500 \times GH¢750) \times 0.45 – GH¢800,000 = GH¢1,393,750
    • Year 2: (7,500×GH¢750)×0.45−GH¢800,000=GH¢1,731,250(7,500 \times GH¢750) \times 0.45 – GH¢800,000 = GH¢1,731,250
    • Year 3: (8,000×GH¢600)×0.45−GH¢800,000=GH¢1,360,000(8,000 \times GH¢600) \times 0.45 – GH¢800,000 = GH¢1,360,000
    • Year 4: (7,800×GH¢600)×0.45−GH¢800,000=GH¢1,306,000(7,800 \times GH¢600) \times 0.45 – GH¢800,000 = GH¢1,306,000
    • Year 5: (7,000×GH¢600)×0.45+600,000−GH¢800,000=GH¢1,690,000(7,000 \times GH¢600) \times 0.45 + 600,000 – GH¢800,000 = GH¢1,690,000
  • 15 Marks

MA – April 2022 – L2 – Q4a – Discounted cash flow

Evaluate the acceptability of a project using the Net Present Value (NPV) method considering cash flows and cost of capital.

Phil Company is considering replacing its existing machine on the introduction of a new product. The existing machine would be sold for GH¢2 million and replaced with a new machine at the beginning of the year at the cost of GH¢16 million. This new machine would be sold at the end of year 4 for GH¢1 million.

A market research recently carried out at a cost of GH¢1.5 million indicates a unit selling price of GH¢300 in year 1, rising by 10% per annum. Sales volume for the four-year life of the project has been estimated as follows:

Year Units
1 60,000
2 85,000
3 85,000
4 80,000

Possible unit variable costs are as follows:

Probability GH¢
0.4 240
0.6 260

Incremental fixed cost as a result of the project is GH¢15 per unit plus GH¢1,000,000 per annum staff cost.

The introduction of the new product is expected to reduce the market demand for an existing product by 5,000 units per annum. The existing product has a unit contribution of GH¢75.

Other annual fixed costs associated with the new product include the following:

  • Amortization of goodwill: GH¢50,000
  • Depreciation: GH¢250,000

Phil Company’s cost of capital is 12%.

Required:

Evaluate the acceptability of the project.

a)

NPV = 1,792,844
Recommendation: The project is acceptable in view of positive NPV

Working 1. Expected variable cost per unit = (GH¢240 x 0.4) + (260 x0.6) = GH¢252
Working 2. Loss contribution 5,000 x GH¢75 = GH¢375,000
Working 3. Initial cost – disposal (16,000,000- 2,000,000) = GH¢14,000,000

  • 12 Marks

MA – Nov 2016 – L2 – Q5a – Discounted cash flow

Calculate the NPV break-even point under different cost of capital scenarios and determine the project's duration based on given cash inflows.

DDB Limited has decided to set up a factory to process groundnuts into oil. The feasibility studies cost them GH¢35,000. The consultants have advised that the initial outlay will be GH¢250,000; however, they were unable to estimate the cash inflow due to the uncertain economic environment.

Required:
Using NPV as an appraisal technique, you are required to calculate:

i) The constant cash inflow needed to break even if the cost of capital is 15% and the project is to last for 10 years.

(4 marks)

ii) By how much should the cash inflow increase to break even if the cost of capital is increased to 20%. (4 marks)

iii) If the cash inflow is GH¢45,000, for how long should the project run to break even if the cost of capital is 15%.

(4 marks)

i) Constant Cash Inflow Needed to Break Even at 15% Cost of Capital:

  • Initial outlay: GH¢250,000
  • Annuity factor (15% for 10 years): 5.019
  • Break-even cash inflow (CF) = GH¢250,000 / 5.019 = GH¢49,810.72

(Total: 4 marks)

ii) Cash Inflow Increase Needed to Break Even at 20% Cost of Capital:

  • Initial outlay: GH¢250,000
  • Annuity factor (20% for 10 years): 4.192
  • Break-even cash inflow (CF) = GH¢250,000 / 4.192 = GH¢59,637.40
  • Increase in cash inflow = GH¢59,637.40 – GH¢49,810.72 = GH¢9,826.68
  • Percentage increase = (GH¢9,826.68 / GH¢49,810.72) × 100 = 19.7%

(Total: 4 marks)

iii) Duration Needed to Break Even at 15% Cost of Capital with GH¢45,000 Cash Inflow:

  • Initial outlay: GH¢250,000
  • Given cash inflow: GH¢45,000
  • Required annuity factor (AF) = GH¢250,000 / GH¢45,000 = 5.556
  • This annuity factor lies between years 12 (5.421) and 13 (5.583)
  • Interpolating between year 12 and year 13:
    • (0.135 / 0.162) × 12 = 0.833 year
    • Therefore, the project should run for 12 years and 10 months to break even.

(Total: 4 marks)

  • 10 Marks

FM – April 2022 – L2 – Q4b – Introduction to Investment Appraisal

Calculate the Accounting Rate of Return (ARR) for three projects and provide advice on which projects should be undertaken based on a target ARR.

SAKAMA Ghana Ltd uses the Accounting Rate of Return (ARR) as the basis of evaluating projects for investment of its scarce financial resources. It uses its predetermined expected return on capital as the basis for the choice of investment projects. The company’s Finance team has provided the information below regarding various projects and their initial investments and net cash flows. The hurdle rate or target Accounting Rate of Return for SAKAMA Ghana Ltd is 25%.

Required:
i) Calculate the Accounting Rate of Return for each project (Average Investment basis). (7 marks)
ii) Using the target return of 25%, advise SAKAMA Ghana Ltd which projects should be undertaken. (3 marks)

i) Calculation of the Accounting Rate of Return (ARR) for each project:

Project A:

Average Annual Accounting profit =
= =200,000

Average Annual Investment =

ARR =

Project B:
Average Annual Accounting profit =
= =220,000
Average Annual Investment =

ARR =

Project C:
Average Annual Accounting profit =
Average Annual Investment =
ARR =

ii) Advice on Projects:
Given the target ARR of 25%, the projects with ARR above this target should be accepted. Therefore, SAKAMA Ghana Ltd should undertake Projects A and B as they both have ARR above the target rate, while Project C should not be undertaken as its ARR is below the target.

 

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