Question 8

Olu ltd prepares its accounts to December 31 each year. It is considering investing in a new computer controlled production facility on January 1, 2016 at a cost of GHS50 million. This will enable Olu Ltd to produce a new product which it expects to be able to sell for four years. At the end of this time it been agreed to sell the new production facility for GHS1 million cash.

Sales of the product during the year ended December 31, 2016 and the next three years are expected to be as follows:

Year ended December 31 2016 2017 2018 2019

Sales in units (000) 100 105 110 108

Selling price, unit variable cost and fixed overhead cost (excluding depreciation) are expected to be as follows during the year ended December 31, 2016.

GHS

Selling price per unit 1,200

Variable production cost per unit 750

Variable selling and distribution cost per unit 100

Fixed production cost for the year 4,000,000

Fixed selling and distribution cost for the year 2,000,000

Fixed administration cost for the year 1,000,000

The following rates of annual inflation are expected for each of the years during 2017-2019

%

Selling prices 5

Production costs 8

Selling and distribution costs 6

Administration costs 5

The company pays taxation on its profits at the rate of 30% with half of this being payable in the year in which the profit is earned and the remainder being payable in the following year.

Investments of this type qualify for tax depreciation at the rate of 25% per annum on a reducing balance basis. The Board of Director of Olu Ltd has agreed to use a 12% post-tax discount rate to evaluate the investment.

Required:

1. Advise Olu Ltd whether the investment is financially worthwhile.
2. Calculate the internal rate or return of the investment
3. Explain briefly how real rate or return and money rate or return would be applied in calculating the net present value of a projects cash flow.