CAPITAL BUDGETING QUESTIONS

QUESTION $1$

Sevista Ltd is evaluating the purchase of a new machine to

produce product SEP, which has a short product life$-$cycle due to

rapidly changing technology. The machine is expected to cost

GH&$1$ million. Production and sales of product SEP are

forecasted to be as follows:

Year Production and sales $($units$/$year$)$

The selling price of product SEP $($in current price terms$)$ will be

GH&$20$ per unit, while the variable cost of the product $($in

current price terms$)$ will be GH&$12$ per unit. Selling price

inflation is expected to be $4\%$ per year and variable cost

inflation is expected to be $5\%$ per year. No increase in existing

fixed costs is expected since Sevista Ltd has spare capacity in

both space and labour terms. Producing and selling product SEP

will call for increased investment in working capital.

Analysis of historical levels of working capital within Sevista

Ltd indicates that at the start of each year, investment in working

capital for product SEP will need to be $7\%$ of sales revenue for

that year. Sevista Ltd pays tax of $25\%$ per year in the year in

which the taxable profit occurs. The new machine is expected to

have no scrap value at the end of the four$-$year period. Sevista

Ltd uses a nominal $($money terms$)$ after$-$tax cost of capital of

$12\%$ for investment appraisal purposes.