Question

Bulangililo Investments (BI) has obtained a loan of K310,000 at 15% pa to invest in the latest model of a machine, with an expected life span of 4 years at the end of which the salvage value will be K10,000.
The project will generate the following as in the table below:
Year
0
1
2
3
4
K’000
K’000
K’000
K’000
K’000
Investment
310
Sales
205
346
502
574
Project expenses (Note 1)
123
176
378
426
Taxable profit
82
170
128
148
Taxation
29
60
45
52
Profit after tax
53
110
83
96
All the above estimates have been prepared in terms of present-day costs and prices.
The following additional information is available to you:
Capital allowances (tax depreciation) are allowable for tax purposes against profits at 25% per year on a straight-line basis
Taxation on profits is at 35%
The company’s after-tax cost of capital is 10% per year.
Assume that all receipts and payments arise at the end of the year to which they relate except those in year 0 which occur immediately.
Note 1
The above expenses include the following:
Required: Year
1
2
3
4
Interest
33
33
33
33
Depreciation
75
75
75
75
(a) Calculate the accounting rate of return if the target accounting rate of return is 15%
(b) Use the information above to determine whether the project is viable using the NPV.

Answer 1

(a)

Average Net Profit = (53+110+83+96) / 4 = 85.5

Average asset value = (310 + 10) / 2 = 160

Accounting rate of Return = Average Net Profit / Average asset value

   = 85.5 / 160

= 53.4375%

(b)

Particulars	1	2	3	4
Net Profit after tax	53	110	83	96
Add:Depreciation	75	75	75	75
Cash Flows	128	185	158	171
PV Factor @ 10%	0.9091	0.8264	0.7513	0.6830
PV of Cash Flows	116.3648	152.884	118.7054	116.793

PV of salvage value = 10000(1 - 0.35) * 0.6830 = 6500 * 0.6830 = 4439.5

Total PV of Cash Flow = 4944.2472 (PV of all cash flows + PV of salvage value)

Initial Outlay = 310

NPV = 4944.2472 - 310 = 4634.2472