QUESTION ONE

ETM Co is considering investing in machinery costing K150,000 payable at the start of first

year. The new machine will have a three-year life with K60,000 salvage value at the end of

3 years. Other details relating to the project are as follows.

Year 1 2 3

Demand (units) 25,500 40,500 23,500

Material cost per unit K4.35 K4.35 K4.35

Incremental fixed cost per year K45,000 K50,000 K60,000

Shared fixed costs K20,000 K20,000 K20,000

The selling price in year 1 is expected to be K12.00 per unit. The selling price is expected

to rise by 16% per year for the remaining part of the projects life.

Material cost per unit will be constant at K4.35 due to the contract that ETM has with its

suppliers. Labor cost per unit is expected to be K5.00 in year 1 rising by 10% per year

beyond the first year. Fixed costs (nominal) are made of the project fixed cost and a share

of head office overhead. Working capital will be K35,000 per year throughout the projects

life. At the end of three years working will be recovered in full.

ETM pays tax at an annual rate of 35% payable one year in arrears. The firm can claim

capital allowances (tax-allowable depreciation) on a 20% reducing balance basis. A

balancing allowance is claimed in the final year of operation.

ETM uses its after-tax weighted average cost of capital of 15% when appraising investment

projects. The target discounted payback period is 2 years 6 months.

Required:

a) Calculate the net present value of buying the new machine and advise on the

acceptability of the proposed purchase (work to the nearest K1).

b) Calculate the internal rate of return of buying the new machine and advise on the

acceptability of the proposed purchase (work to the nearest K1).

c) Calculate the discounted payback period of the project and comment on the results.

d) Briefly discuss why good projects are very difficult to find as well as challenging to

maintain or sustain.

Page 2 of 3QUESTION TWO

B plc has the following capital structure:

K000

Ordinary shares K0.40 5,000

Retained earnings 500

10% Preference shares at K1 1,500

10% K100 redeemable debentures 3,000

Total funds employed 10,000

The market price of the preference shares is 80n ex-div, the ordinary shares are quoted at

K1.62 cum-div per share. Debenture stock is quoted at K97.5 ex-interest per K100 nominal

and will be redeemable at par in exactly 7 years time.

B plc has just declared dividend of K1,500,000 in total for all issued ordinary shares. The

dividend growth rate is 4% per year forever. Company tax is 30% per year. The market rate

of return is 12% and the company has an equity beta value of 1.25

Required:

a) Calculate WACC based on market values.

b) Discuss the implications of using a wrong WACC value in project appraisal and

comment on the current level of capital gearing.