Critically assess the use of NPV and IRR as investment appraisal tools.

Strategic Financial Management

QUESTION 1

John plc is a leading supplier of sauces to the food industry. It has recently been
experiencing increased demand for one of its main products (product X) and must increase its production capacity to meet demand.

A new machine, with a useful life of four years and a maximum output of 600,000 kg of product X per year, could be bought for €800,000, payable immediately. The scrap value of the machine after four years is expected to be €30,000.
John plc has a policy of depreciating machines in the annual accounts on a straight-line basis over its useful economic life. John plc will finance the purchase of the new machine by means of a bank loan at a fixed rate of interest of 8% per annum.

Forecast demand and production of product X over the next four years is as follows:

Year                                      1                 2                         3                           4

Demand (kg)                 1·4 million      1·5 million         1·6 million        1·6 million

Existing production capacity for product X is limited to one million kilograms per year and the new machine would only be used for demand additional to this.

The additional production will take place in a building which John plc purchased two years ago for €1.5m. The building is currently unoccupied due to the excess of property available in the market. Demand for property is not expected to pick up for at least the next four years.

The current selling price of product X is €7.50 per kilogram and the variable cost of materials is €4.50 per kilogram. Other variable costs of production are €1·90 per kilogram. It is not expected that these will change over the next four years.

Fixed costs of production associated with the new machine would be €240,000 in the first year of production, increasing by €20,000 per year in each subsequent year of operation.

John plc pays tax one year in arrears at an annual rate of 30% and can claim capital
allowances on a 25% reducing balance basis. A balancing allowance is claimed in the final year of operation.

John plc uses its after-tax weighted average cost of capital when appraising investment projects. It has a cost of equity of 12% and a before-tax cost of debt of 7·6%. The long-term finance of the company, on a market-value basis, consists of 70% equity and 30% debt.

You are required to :

(a) Critically assess the use of NPV and IRR as investment appraisal tools. (20 Marks)

(b) Calculate the net present value of buying the new machine and advise on the
acceptability of the proposed purchase (work to the nearest €1,000). (15 marks)

(c) Calculate the internal rate of return of buying the new machine and advise on the
acceptability of the proposed purchase (work to the nearest €1,000). (5 marks)

(d) Describe how sensitivity analysis and probability analysis can be used to incorporate risk into the investment appraisal process. (10 marks)

(Sub-total 50 marks)

QUESTION 2

Stratus Ltd. is in the process of preparing its budgets for the period October 2022 to
December 2022. The following information is provided to assist in the budgeting process:

1. Budgeted monthly sales revenue is as follows:
€
August              90,000
September      100,000
October          120,000
November      160,000
December       140,000

Sales are 20% cash and 80% credit. Credit sales are collected over a two-month
period, 40% in the month following sale and 60% in the month after that. Sales in
January 2023 are expected to be €190,000.

2. Cost of sales is expected to amount to 65% of sales revenue each month.

3. Closing inventory levels are held at 50% of the following month’s sales revenue.
Inventory at the beginning of October is expected to amount to €60,000.

4. 85% of inventory purchased is paid for in the month of purchase. The remaining 15% is paid for in the month following purchase. Trade payables are €25,000 at 1st
October.

5. Stratus Ltd. plans to apply for a government grant of €32,000 and it is expected this
grant will be received in two equal amounts in November and December. The
application for this grant will cost €1,500 which will be paid in October.

6. A van is expected to be sold in December for €15,000. Immediately prior to the sale,
Stratus Ltd. expects to spend €1,750 on repairs and maintenance in order to ensure
the van will be in a workable condition.

7. Equipment costing €17,250 will be purchased and paid for in November. It will be
depreciated on a straight line basis over five years.

8. Operating expenses for October are estimated at €12,000 and will increase by 10%
per month, thereafter. These expenses will be paid as incurred.

9. The cash balance on 1st October is expected to amount to €104,000.

You are required to:

(a) Calculate the purchases figure for each month from October 2022 to December
2022.
(5 Marks)

(b) Prepare a cash budget on a monthly basis and in total for the period October
2022 to December 2022. (15 Marks)

(c) Outline any five potential benefits from the preparation of a cash budget as
prepared in part (b). (10 Marks)

(d) Outline five benefits which the use of IT brings to the preparation
And use of a cash budget.

Last Completed Projects