A company is reviewing an investment proposal in a project involving a capital outlay of GHS 9,000,000 in plant and machinery. The project would have a life of 5 years at the end of which the plant and machinery could fetch a resale value of GHS 3,000,000. Further, the project would also need a working capital of GHS 1,250,000 which would be built during the year 1, increase by 5% every year and to be released at the end of the project. The project is expected to yield the following cash profits:
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
A company is reviewing an investment proposal in a project involving a capital outlay of GHS
9,000,000 in plant and machinery. The project would have a life of 5 years at the end of which
the plant and machinery could fetch a resale value of GHS 3,000,000. Further, the project would
also need a working capital of GHS 1,250,000 which would be built during the year 1, increase
by 5% every year and to be released at the end of the project. The project is expected to yield the
following cash profits:
Year
1
2
3
4
5
Cash Profit (GHSm) 3.5
3.0
2.5
2.0
2.0
A 25% deprecation for plant and machinery is allowed as income tax exemption on reducing
balance basis. Assume that the corporate tax is paid in the same year to which it relates and every
year’s deprecation allowance will be claimed against the same year.
The assistant finance manager has calculated the NPV of the project using the company’s
corporate target of 20% pre-tax
cashflows. As the newly recruited finance manager, you realised that the projects cashflows
should incorporate the effects of tax. The corporate tax is expected to be 35% during the life of
the project and thus the company’s rate of return post-tax is 13% (65% of 20%).
Your assistant is surprised to note the difference between discounting the pre-tax cash flows at a
pre-tax discounted cash flow rate and post-tax cashflows at a post-tax rate
Required:
(a) Calculate the NPV of the projects as the assistant finance manager would have calculated it
(b) Re-calculate the NPV of the project taking tax into consideration
(c) Comment on the desirability of the project based on your findings in part (b)
NOTE: (Present your answers in thousands of GHS)
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