QUESTION 1 (Cost-Benefit analysis of gravel road maintenance)

The Managing Director, Roads infrastructure, has to decide whether to continue operating the in-house gravel road maintenance services or close it down and contract in an external service provider. Determine the best option for the next five years, accepting that the roads to be serviced will remain functional and grading and maintenance are done per annum. Road Infrastructure will receive R20m in revenue in the first year of operations, and this amount will increase by 8% per year. Use a discount rate of 10%, and tax rate of 27%.

OPTION 1: In-house service: This option requires covering maintenance costs of the facilities and the budget in year one for this item is R1 500 000, an amount which will escalate by 5% per annum until the end of the five year period. It however also requires immediate acquisition of urgently required new equipment at a cost of R15 750 000, with training cost of R250 000, and installation cost of R1 250 000. The book value of the equipment will be R200 000 at the end of the fiver year period. Staff salaries and materials will amount to R11 095 000 in year one and will escalate by 8% per annum. Inventory of R200 000 will be required at the start of the project.

OPTION 2: Service Provider Contract: This option requires entering into a contract whereby a service provider is paid a base amount of R860 000 per month (R10, 32 million per annum) starting in year one. This amount escalates by 7% per annum. Provision is made for material in the contract at R6 050 00 in year one, with escalation of 10% per annum.

Determine both NPV and the IRR.

QUESTION 2 (Further analysis of 5 year road construction programme)

Road infrastructure has a budget of R45 000 000 for staff costs of employment and R20 000 000 for operating expenses during the financial year. Their share in overhead allocation amounts to R10 000 000. These are all fixed costs.

In addition, they spend in average R25 000 per km of road constructed on travelling and other expenses such as legal and consultant fees, and the construction cost per km amounts to R95 000. These are variable costs.

Immediate acquisition of urgently required new equipment will be required at a cost of R15 750 000. The book value of the equipment will be R200 000 at the end of the five year period.

The tax rate is 27%, and the required rate of return is 8%.

1. How many km of road should be constructed per year for Road Infrastructure to justify its existence financially if the total allocation for road construction amounts to R130 000 per km? Make use of cash , accounting and financial break even calculations.

2. What is the degree of operating leverage at 10 000 kms, and what would the effect be on the OCF if an additional 1000 kms are then constructed?