QUESTION ONE [50] Diamond Merchant Ltd produces crushed Diamond used in exclusive jewelled pieces across South Africa. The company operates 50 diamond crushing plants across the country and because of the nature of the business, accuracy in terms of weighting orders is essential. At present, at each plant, clerks prepare delivery notes for customers, weigh the product to be dispatched and record details of each delivery. Owing to the inefficiency and inaccuracy of the clerks, the company is considering replacing them with a computerised system at each plant. On average, the financial implications of this decision, per plant, at current prices are as follows: Note R'000 1400 Computerised equipment - initial outlay Operating costs per annum: 1 600 Present labour-based method 1 500 Proposed computerised method Transportation cash costs per annum Associated with present system 200 100 Associated with proposed system Notes . 1. The estimate of R 1500 000 for the proposed computerised method includes straight- line depreciation of R300 000 calculated on the equipment's net cost. (Net cost= Initial outlay less proceeds on disposal at the end of the asset's four year life). The disposal proceeds have been estimated at current prices for the purposes of calculating net cost. There is no depreciation incurred using the present labour based method. 2. The cost of the computerised equipment, the disposal proceeds and operating costs are all expected to increase at the general rate of inflation of 8%. The transportation costs, however, are expected to inflate at a rate of 7% per annum. Income tax rates applicable to Diamond Merchant: 1. Tax is payable at the rate of 40% in the year incurred (i.e. it is not payable in arrears). 2. As an incentive to encourage investment, computerised equipment of this nature can be written off for tax purposes in equal instalments over three years. The annual depreciation allowance is based on the initial outlay at current prices and ignores the estimated disposal value. Any proceeds on disposal at the end of the asset's useful life are taxed at the normal rate of 40%. 1. Tax is payable at the rate of 40% in the year incurred (i.e. it is not payable in arrears). 2. As an incentive to encourage investment, computerised equipment of this nature can be written off for tax purposes in equal instalments over three years. The annual depreciation allowance is based on the initial outlay at current prices and ignores the estimated disposal value. Any proceeds on disposal at the end of the asset's useful life are taxed at the normal rate of 40%. If the proposal is accepted, a loan, bearing interest at the nominal (i.e. money) rate of 10% per annum before tax, will be raised to finance the entire initial outlay. The company's nominal and real after tax cost of equity is 20% and 11,11% per annum respectively. The target debt equity ratio is 50:50 and the pooling of funds principle is adopted in determining the appropriate discount rate for evaluating capital investments. All cash flows, apart from the initial outlay which will occur immediately if the project is accepted, are assumed to take place at the end of each year. REQUIRED: (a) Explain, showing calculations if necessary, what discount rate you will use to evaluate the proposed investment. marks) (b) Calculate the net present value of the proposed investment in computerised equipment for the company as a whole (i.e. all 50 plants). (30 marks) (Note: If you feel it is appropriate to inflate cash flows, this should commence immediately, i.e. the Year 1 amounts would have one year's inflation incorporated.) All calculations to the nearest R1000. (c) Discuss the following statement: 'The internal rate of return (IRR) method and the net present value (NPV) method are both discounted cash flow techniques of project appraisal. Both of these methods will in all circumstances guide managers to make the same capital expenditure decisions. (12 marks) QUESTION ONE [50] Diamond Merchant Ltd produces crushed Diamond used in exclusive jewelled pieces across South Africa. The company operates 50 diamond crushing plants across the country and because of the nature of the business, accuracy in terms of weighting orders is essential. At present, at each plant, clerks prepare delivery notes for customers, weigh the product to be dispatched and record details of each delivery. Owing to the inefficiency and inaccuracy of the clerks, the company is considering replacing them with a computerised system at each plant. On average, the financial implications of this decision, per plant, at current prices are as follows: Note R'000 1400 Computerised equipment - initial outlay Operating costs per annum: 1 600 Present labour-based method 1 500 Proposed computerised method Transportation cash costs per annum Associated with present system 200 100 Associated with proposed system Notes . 1. The estimate of R 1500 000 for the proposed computerised method includes straight- line depreciation of R300 000 calculated on the equipment's net cost. (Net cost= Initial outlay less proceeds on disposal at the end of the asset's four year life). The disposal proceeds have been estimated at current prices for the purposes of calculating net cost. There is no depreciation incurred using the present labour based method. 2. The cost of the computerised equipment, the disposal proceeds and operating costs are all expected to increase at the general rate of inflation of 8%. The transportation costs, however, are expected to inflate at a rate of 7% per annum. Income tax rates applicable to Diamond Merchant: 1. Tax is payable at the rate of 40% in the year incurred (i.e. it is not payable in arrears). 2. As an incentive to encourage investment, computerised equipment of this nature can be written off for tax purposes in equal instalments over three years. The annual depreciation allowance is based on the initial outlay at current prices and ignores the estimated disposal value. Any proceeds on disposal at the end of the asset's useful life are taxed at the normal rate of 40%. 1. Tax is payable at the rate of 40% in the year incurred (i.e. it is not payable in arrears). 2. As an incentive to encourage investment, computerised equipment of this nature can be written off for tax purposes in equal instalments over three years. The annual depreciation allowance is based on the initial outlay at current prices and ignores the estimated disposal value. Any proceeds on disposal at the end of the asset's useful life are taxed at the normal rate of 40%. If the proposal is accepted, a loan, bearing interest at the nominal (i.e. money) rate of 10% per annum before tax, will be raised to finance the entire initial outlay. The company's nominal and real after tax cost of equity is 20% and 11,11% per annum respectively. The target debt equity ratio is 50:50 and the pooling of funds principle is adopted in determining the appropriate discount rate for evaluating capital investments. All cash flows, apart from the initial outlay which will occur immediately if the project is accepted, are assumed to take place at the end of each year. REQUIRED: (a) Explain, showing calculations if necessary, what discount rate you will use to evaluate the proposed investment. marks) (b) Calculate the net present value of the proposed investment in computerised equipment for the company as a whole (i.e. all 50 plants). (30 marks) (Note: If you feel it is appropriate to inflate cash flows, this should commence immediately, i.e. the Year 1 amounts would have one year's inflation incorporated.) All calculations to the nearest R1000. (c) Discuss the following statement: 'The internal rate of return (IRR) method and the net present value (NPV) method are both discounted cash flow techniques of project appraisal. Both of these methods will in all circumstances guide managers to make the same capital expenditure decisions. (12 marks)