QUESTION THREE

A piece of equipment requiring the investment of 2.2 million is being considered by Charo Foods Ltd. The equipment has a ten-year useful life and an expected salvage value of Sh 200,000.The company uses the straight-line method of depreciation for analysing investment decisions and faces a tax rate of 40%.For simplicity assume that the depreciation method is acceptable for tax purposes.

A pessimistic forecast projects cash earnings before depreciation and taxes at Sh 400,000 per year compared with an optimistic estimate of Sh 500,000 per year.The probability associated with the pessimistic estimate is 0.4 and 0.6 for the optimistic forecast.The company has a policy of using a hurdle rate of 10% for replacement investments, 12% (its cost of capital) for revenue expansion investments into existing product lines and 15% projects involving new areas or new product lines.

REQUIRED:

(a)Compute the expected annual cash flows associated with the proposed equipment investments. (4 marks)

(b)Would you recommend acceptance of this project if it involved expansion of sales for an existing product?(5 marks)

(c)Would it be acceptable if it was for the replacement of equipment with a book value of Sh 200,000 at the end of the tenth year but which could be sold at that time for only Sh 40,000?(5 marks)

(d)Discounted cashflow methods were developed for idealised settings of complete and perfect capital, factor and commodity markets.Explain what complications arise when an attempt is made to apply these methods in real life markets that are neither complete nor perfect.(6 marks)

(Total: 20 marks)