Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

Ceder Ltd has details of two machines which could fulfill the company‟s future production
plans. Only one of these machines will be purchased.

The „standard‟ model costs Sh.50,000, and the „de-luxe‟ Sh.88,000, payable immediately. Both machines would require the input of Sh.10,000 working capital throughout their working lives, and both machines have no expected scrap value at the end of their expected working lives of four years for the standard machine and six years for the de-luxe machine.

The forecast pre-tax operating net cash flows associated with the two machines are:
The de-luxe machine has only recently been introduced to the market and has not been fully tested in operating conditions. Because of the higher risk involved, the appropriate discount rate for the de-luxe machine is believed to be 14% per year, 2% higher than the discount rate for the standard machine.

The company is proposing to finance the purchase of either machine with a term loan at a fixed interest rate of 11% per year.

Taxation at 35% is payable on operating cash flows one year in arrears, and capital allowances are available at 25% per year on a reducing balance basis.

You are required:
(a) to calculate for both the standard and the de-luxe machine:

(i) pay-back period;

(ii) net present value

Recommend, with reasons, which of the two machines Ceder Ltd should purchase.

(Relevant calculations must be shown)

(b) If Ceder Ltd were offered the opportunity to lease the standard model machine over a four year period at a rental of Sh.15,000 per year, not including maintenance costs, evaluate whether the company should lease or purchase the machine.
ANSWER

CEDER LTD

Payback period is approximately for four years

Net present value is Sh.5,510

** Assumes working capital is released immediately. In reality some time-lag will exist.

Normally the project with the highest NPV would be selected. However projects have unequal lives, it can be argued that although the de-luxe higher NPV, this is only achieved operating for two more years. The machines are to fulfill a continuing production requirement the time factor to be considered.

The annual equivalent cost approach is not appropriate as both machines have different level of risk. In this situation the most useful approach is to … infinite reinvestment in each machine and calculate their NPVs to infinity.


≠ The present values of annuities are taken for four and six years as these are the useful lives of the projects.

As the standard machine has the higher NPV ∞, it is recommended that this machine should be purchased.
An alternative approach to the problem of different lives might be to assume a reinvestment rate for the shorter investment and to use this rate to equalize the lives of the investments.

(b) Lease payments are usually made at the start of the year.

As the net present value is negative, it appears that the purchase of the machine is the recommended alternative.

The choice of discount rates in lease versus buy analysis is contentious. The approach used here is to regard the lease as an alternative to purchasing the machine using debt finance. The discount rate is, therefore, the amount that the company would have to pay on a secured loan on the machine, the loan being repayable on the terms that are implicit in the lease rental schedule. This discount rate is the after-tax cost of the equivalent loan, 11%(1-0.35) = 7.15%.

This discount rate is only likely to be valid if leases and loans are regarded investors as being equivalent, and all cash flows are equally risky.

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