Financial management revision question & answer

The Weka Company Ltd. has been considering the criteria that must be met before a capital expenditure proposal can be included in the capital expenditure programme. The screening criteria established management are as follows:

1. No project should involve a net commitment of funds for more than four years.
2. Accepted proposals must offer a time adjusted or discounted rate of return at least equal to the estimated cost of capital. Present estimates are that cost of capital as 15 percent per annum after tax.
3. Accepted proposals should average over the life time, an unadjusted rate of return on assets employed (calculated in the conventional accounting method) at least equal to the average rate of return on total assets shown the statutory financial statements included in the annual report of the company.

A proposal to purchase a new lathe machine is to be subjected to these initial screening processes. The machine will cost Shs. 2,200,000 and has an estimated useful life of five years at the end of which the disposal value will be zero. Sales revenue to be generated the new machine is estimated as follows:

Year Revenue (Sh.‟000‟)
1 1,320
2 1,440
3 1,560
4 1,600
5 1,500

Additional operating costs are estimated to be Shs. 700,000 per annum. Tax rates may be assumed to be 35% payable in the year in which revenue is received. For taxation purpose the machine is to be written off as a fixed annual rate of 20% on cost.

The financial accounting statements issued the company in recent years shows that profits after tax have averaged 18% on total assets.

Required:
Present a report which will indicate to management whether or not the proposal to purchase the lathe machine meets each of the selection criteria.
answer
Depreciation p.a. = 20% x 2,200,000 = 440,000

Prepare a cash flow schedule:

Screening Criteria
1. The net commitment of funds should not exceed 4 years i.e the payback period should at least be 4 years. Therefore, compute the payback period.

The initial capital of Sh.2,200,000 is recovered after year total of Sh.295,000 (2,200 – 1,905) is required out of

3.After year 3 (during year 4) a the total year 4 cash flows of

Since the NPV is negative at 15% cost of capital rediscount the cash flows again at a lower rate, say 14%, to get a positive NPV.

3. The unadjusted rate of return on assets employed is the accounting rate of return

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