QUESTION 4 (25 Marks)

REQUIRED Study the information given below and answer the following questions:

4.1 Calculate the Accounting Rate of return (on initial investment) of the first alternative. (5 marks)

4.2 Determine which of the two investment opportunities the company should choose. Motivate your answer by comparing the Net Present Value of each alternative. (15 marks)

4.3 Calculate the Internal Rate of Return of the first alternative, if no salvage value is expected. (5 marks)

INFORMATION The management of Hemrock Ltd is considering two investment opportunities:

The first alternative involves the purchase of new equipment for R440 000 which will enable the company to modernise its maintenance facility. The equipment is expected to have a useful life of five years and a R22 000 salvage value. On the day Hemrock Ltd purchases the new equipment, it would also pay the equipment manufacturer R16 500 for training costs to teach the employees to operate the new equipment. The modernisation is expected to increase efficiency, resulting in a reduction of R118 250 in annual cash operating expenses.

The second alternative involves purchasing a truck. Purchasing another truck will enable the company to expand its delivery area and increase revenue. The estimated cost of the truck is R632 500. Its useful life is expected to be five years and a salvage value of R165 000 is anticipated. Operating the truck will necessitate an increase in inventory of supplies, petty cash, and its accounts receivable and payable balances. These changes would add R27 500 to the companys working capital base immediately upon purchasing the truck. The working capital cash outflow is expected to be recovered at the end of the trucks useful life. The truck is expected to generate R379 500 per year in additional revenues. The drivers salary and other cash operating expenses are expected to be R176 000 per year. A major overhaul costing R110 000 is expected to be required at the end of the third year of operation.

Hemrock Ltd desires a rate of return of 14%. The straight-line method of depreciation is used