The board of directors of the Kaluma Power Corporation has decided that, for the purpose of testing whether its capital investment projects are acceptable, a compound interest (DCF) rate of 8% per annum will be used in evaluating investment projects.
All investment project is now under consideration. Estimates of the expected cash flows over forty years, are as follows:
The expected residual value of the assets is zero.
(a) Show whether the project satisfies the normal capital budgeting criteria for acceptance.
(b) Show how sensitive the calculation in (a) above is to:
(i) An increase in the residual asset value from zero to sh.1,000,000.
(ii) A 1% increase in the initial capital outlay (during each year of the outlay).
(iii) A 1% decrease in the estimate of expected cash flow during each
of the years from 6 to 10.
(c) Show the effect of adopting the project on the ratio of reported profits in years 5 and 6 to net balance sheet value of assets at the beginning of those two years. Comment briefly on the usefulness of the latter type of ratio in the interpretation of accounts in the light of your calculation. (Assume that the expenditure in years 1 to 5 is capitalised, that straight-line depreciation is charged after year 5 at 5% per annum, and the actual cash flows are according to plan).
You can assume that all cash flows arise on the last day of each year, that all figures are net of tax and expressed in terms of constant price levels, and that working capital for the investment project can be ignored.
The project does not satisfy normal capital budgeting criteria.
(b) (i) If residual increased 1,000,000 then
Percentage decrease to a % change in initial capital especially because it occurs in the early years of economic life.
(iii) A 1% decrease in year 6 – 10 cash flows means 1% x 1500 = 15m decrease p.a. The NPV would decrease 15m(6.710 – 3.993) = 40.76
The effect of adopting the project would be to show a sh.8 million increase in the net balance sheet value of assets, with no corresponding increase in revenue. The ratio (return on capital employed) would therefore become more unfavourable.
The effect of including the project in the ratio in year 6 would be to increase revenue Sh.1 million (Sh.1.5 – 0.5 million) depreciated and to increase net asset values in that year Sh.2 million (sh.10 million in total). This would improve the ratio.
The usefulness of such a ratio is arguable as it does not take into account expectations of the future returns on capital invested in the present period.
Any capital invested on the basis suggested in the question will have an unfavorable effect on the ratio in the early years of the project as no credit is taken for expected returns until they are received.