Financial management revision question and answer

CPA-Financial-Management-Section-3 Revision kit

Mwongozo Limited has approached you for advice on an equipment to be purchased for use in a five year project.

The investment will involve an initial capital outlay of Shs. 1.4 million and the expected cash flows are given below:

The equipment is to be depreciated on a straight line basis over the duration of the project with a nil residual value.
The cost of capital and the tax rate are 12% and 30% respectively.

The net present value (NPV) of the investment.

(b) Beta Leather Company Limited is considering acquiring an additional leather processing machine at a cost of Shs. 18 million. The machine is expected to generate after tax savings of Shs. 3,600,000 per year over an eight year period.
The policy of the company is to finance capital investments with a 50% debt. The company is able to borrow Shs. 9 million at 10% interest per annum to finance the purchase of the machine in part. The loan principal is to be paid in equal annual instalments of Shs. 1,125,000 payable at the year end. The company‟s required rate ofreturn is 13% and the company is in the 30% tax bracket.

(i) The net present value (NPV) of the machine if fully financed equity to acquire the machine. Advise the management on whether to finance it equity or loan.
(ii) The net present value (NPV) of „the machine with part debt financing. Would your advice to the management in (b) (i) above change?

The management should change and partly use 50% debt financing to enjoy interest tax shield which reduces the cost of capital and improved returns to shareholders.

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