Question 1

a. You are the manager of a small firm that is into agro-industry that manufactures canned tomatoes, which tend out to be profitable. A recent market research shows that there will be high demand for canned tomatoes in the years ahead. Based on this, the company secured a loan of Ghs 500,000 to expand its business. The interest rate for the loan is 15% per year compounded semi-annually and it is due in 5 years.

i. Determine the effective interest rate of the loan.

ii. Determine the effective interest rate if the quoted interest rate was compounded annually.

iii. Suppose the Ghs 500,000 could be secured either from Bank Z based on the effective interest rate in question (i) or from Bank K based on the effective interest rate in question (ii). As the manager of the small agro-industry firm, which of the two options would you choose and why?

b. A trust fund is to be established by a single payment so that at the end of 15 years, there will be Ghs 20,000 in the fund. If the fund earns interest at the rate of 8% per year compounded semi-annually

i. How much should be deposited initially into the fund?

ii. Based on question (i) above, calculate the value of the loan at the end of the fifth year based on the nominal interest rate.

c. You are the expert employed by a company to evaluate a project to assess if you have to invest in such a project or not. Suppose you are using the Net Present Value (NPV) criteria, explain to the manager.

i. What does NPV > 0 mean (provide an intuitive interpretation of this)?

ii. What is Internal Rate of Return (IRR)? How is it calculated and list two disadvantages of IRR as an investment appraisal tool.

d. An energy company is considering investing into the construction of a power plant. There are two power plant options open to the company. The first involves constructing a power plant that will take 5 years to complete. The plant when constructed has a useful life of 30 years. In each of the 5 years of construction it cost the company Ghs 12,000,000. The plant will start operation in year 6 and will generate net revenue of Ghs 5,550,000 and this will be the same amount of net revenue per year for the rest of the useful life of the project. The second project involves the construction of a power plant in a different location that has a useful life of 35 years. The cost of construction is 17,200,000 per year and it will take 6 years to complete. Power production will start in the 7th year and will generate net revenue of Ghs 9,090,000 and this will be the amount per year for the rest of the useful life of the project.

i. Draw a cash flow diagram for each of the projects (note the cash flows are the cost and revenue of the company).

ii. Based on the NPV criteria and interest rate of 6%, which project should the company invest in?

iii. What is the annual worth of each project based on the annual worth criteria and an interest rate of 6%? Which project will you recommend based on this criterion?

iv. Which of the two (NPV or Annual worth) approaches is appropriate for evaluating the two projects presented above?