QUESTION 1 MULTIPLE CHOICE QUESTIONS

QUESTION 1 MULTIPLE CHOICE QUESTIONS SOURCE: YEAR TEST 3 (2009) 1. Given the various long-term project evaluation techniques, generally speaking which of the following combination of techniques represents the most appropriate and least appropriate techniques to use? Most appropriate Least appropriate A. NPV Payback Please note B. IRR ARR NPV = Net Present Value C. NPV IRR IRR = Internal Rate of Return D. IRR Payback ARR = Accounting rate of Return E. NPV ARR 2. Which of the following may lead to potentially incorrect evaluation of long-term projects when applying the internal rate of return (IRR) evaluation technique? A. The size of the initial investment B. The timing of the cash inflows C. Unconventional cash-flows D. All of the above E. None of the above SOURCE: YEAR TEST 3 (2008) 3. Matusadona Company plans to invest R450 000 in a new factory. Using a discount rate of 14%, the present value from the factory is R483 000. To yield a 14% internal rate of return, the actual investment cost cannot exceed the R450 000 estimate by more than A. R63 000. B. R33 000. C. R16 500. D. This cannot be determined from the information given. 4. A project requires an investment of R90 000 in equipment at the start of the project. Annual cash inflows of R15 000 (excluding depreciation) are expected to occur for the next ten years. No salvage / scrap value is expected. If the annual cash inflows occur evenly throughout the year, the payback period for the project would be A. 4.5 years. B. 4.8 years. C. 5 years. D. 6 years. 1

The following information relates to questions 5 and 6 only: Capex Limited is considering investing in the following project: Initial investment R80 000 Annual revenues R50 000 Annual variable costs R15 000 Annual fixed cash costs R10 000 Salvage / scrap value R5 000 Discount rate 12% Expected life of project 8 years Ignore tax. 5. The net present value of the project is: A. R95 886.81 B. B R42 171.58 C. C R44 190.99 D. D R46 210.41 6. Rounded to the nearest two decimals, the internal rate of return of the project is: A. 26.83% B. 41.13% C. 26.48% D. 26.11% 7. Lake Kariba Company is considering buying a new boat that would cost R120 000 upfront. The accountant determined that the boat will yield an internal rate of return of 10% and that it has a useful life of four years. The accountant resigned and the managing director wants to check her calculations. Rounded to the nearest rand, the approximate annual net cash inflows from the project are A. R25 856 B. R30 000 C. R37 856 D. Net cash inflows cannot be determined from the information given. SOURCE: YEAR TEST 3 (2011) 8. A company evaluates all projects at a cost of capital of 12% per annum. The available information for two mutually exclusive projects under consideration is as follows: Option 1 (3 year project): CF 0 : (R 12 000) CF 1 : R 5 000 CF 2 : R 6 000 CF 3 : R 7 000 2

Option 2 (2 year project): CF 0 : (R 12 000) CF 1 : R 7 000 CF 2 : R? Which of the following figures (to the nearest rand), representing CF 2 for option 2 (marked as R?) will leave the company indifferent as to which investment option to take: A. 11 000 B. 10 010 C. 9 181 D. 8 957 E. 5 000 SOURCE: EXAM (2011) The following information only relates to questions 9 and 10. Only the Best (Pty) Limited evaluate their long term projects using a cost of capital of 18% per annum. The following mutually exclusive projects are currently under review: Project 1 CF 0 = (R 500 000) CF 1 = R 150 000 CF 2 = R 200 000 CF 3 = R 250 000 CF 4 = R 300 000 Project 2 CF 0 = (R 500 000) CF 1 = R 450 000 CF 2 = R 150 000 CF 3 = R 100 000 9. Which of the following statements is correct? A. The same amount is invested initially in each project. B. The annual equivalent cash-flow for each project must be determined to fairly evaluate the projects. C. The payback period of project 2 is superior to the payback period of project 1. D. All of the above. E. None of the above. 10. Which of the following statements (to the nearest Rand) is correct? A. The annual equivalent cash-flow for project 1 is R77 650. B. The annual equivalent cash-flow for project 1 is R214 735. C. The annual equivalent cash-flow for project 2 is R549 947. D. The annual equivalent cash-flow for project 2 is R22 972. E. None of the above. 3

QUESTION 2 SOURCE: EXAM (2009) BAGUETTE (PTY) LIMITED Baguette is a newly formed company aiming to supply bread to a local supermarket. Operations have not commenced yet, as the company is considering whether it would be more beneficial to bake the bread themselves or purchase it from a local bakery. The company has already concluded a contract to deliver 300 loaves of bread per day to the local supermarket. The contract stipulates that the first 60 loaves per day will be delivered at a total price of R375 per day and that a selling price of R6 per loaf will apply thereafter. The company can buy the first 150 loaves at R5.70 per loaf per day from the local bakery and this price will reduce by 10% per 150 loaves per day purchased thereafter. Should Baguette decide to bake the breads themselves an oven will have to be hired at a cost of R3 000 per month. The company will have an option to purchase this oven (the hired one) at the end of its first year of operations from the current owner. Two foremen (each at an annual remuneration of R18 000 per annum) will also have to be employed to supervise proper and efficient operation of the oven. The expectation is that company s normal sundry fixed expenses will amount R100 000 per annum and that this will increase by R30 000 per annum (due to electricity) if the oven is used to bake the bread. The following represents the manufacturing costs per bread to be incurred by the company (should the option to bake and distribute the breads be taken): Direct raw materials (yeast, water and flour etc.) R 2.10 Direct labour R 1.60 Variable overheads (bags for packaging) R 0.40 Variable production cost R 4.10 You may assume that bread will be delivered daily for 365 days a year. a) With reference to the first year of operations, determine whether the company should bake the bread themselves or buy them. Clearly indicate any costs/revenues (if any) that you may regard as irrelevant; b) Briefly discuss 4 qualitative factors management should consider before the final decision is taken; and 4

c) Assume that the company has decided to bake the breads and today is last day of the first year of operations and management is now considering whether they should carry out their option to purchase the existing (hired) oven from the current owner. Management obtained the following information regarding the existing (hired) oven as well as a new similar oven to establish which oven would be most beneficial to purchase: Existing New (hired) oven Oven Cost price R240 000 R315 000 Useful life 4 years 5 years After tax net cash inflows (R-value) resulting from use R110 000 R110 000 of oven (before accounting for tax allowances, recoupments or scrapping allowances) Tax wear and tear allowances per annum (Straight-line basis) 20 % (2nd hand asset) 40 % (year 1) 20 % (years 2-4) Statutory tax rate per annum 30 % 30 % Company s weighted average cost of capital per annum: 15 % Neither oven will have any resale value. Advise management, from a purely financial perspective, which oven (the existing or new) would be most beneficial to acquire. 5

QUESTION 3 SOURCE: YEAR TEST 3 (2007) NKGATO S PIMPING STUDIO Nkgato has just started a business selling car pimping accessories in Pretoria. His product range includes light kits, mag wheels, spinning rims and radar detectors. Nkgato has been amazed at the high demand for his car pimping services, but because of the risk of competition he wants to differentiate his business by offering his clients a service whereby the accessories can be fitted at the client s home or work. To do this, he has decided to set up mobile pimping workshops in custom-fitted vans. Nkgato needs your help in deciding between two different types of vehicles. Nkgato s first option is the Tata 207Di, which is a single-cab truck with a double reinforced load box that can carry 1 500kg. The cost price of the standard vehicle is R105 000, but it would have to be modified with a canopy to create the space required for the mobile pimping fitment studio, at a further cost of R75 000. Assume that the canopy and modifications are included in the cost of the asset for tax purposes. The Tata only needs to be serviced every 10 000 km, and the average cost of each service is expected to be R2 500 in the first year, increasing by 10% at the start of each year. The variable cost per kilometre of the Tata is expected to amount to R1.50 per kilometre, excluding diesel, increasing onceoff with 5% at the start of year 3. The Tata is expected to deliver fuel consumption of 10km per litre over its entire useful life, which is expected to be 6 years. At the end of year 5, the residual value of the 207Di will be R35 000. Nkgato s other option is the Vito Panel Van, which has a maximum load of 995kg. The cost price of the standard vehicle is R200 000, and since it is already a closed van the modification costs would only amount to R20 000. Assume that the modification costs are included in the cost of the asset for tax purposes. The purchase price includes a service and maintenance plan that runs for the first 90 000km. Thereafter, the van will have to be serviced every 10 000km at an expected cost of R1 500 per service at that point in time, increasing by 5% at the start of every year thereafter. The variable cost per kilometre of the van is expected to amount to R0.75 per kilometre, excluding diesel, increasing by 2% at the start of each year. The van is expected to deliver 12km per litre over its entire useful life, which is expected to be 7 years. At the end of year 5, the residual value of the van will be R85 000. The panel van has a slightly better image than the 207Di and Nkgato thus expects a slightly higher number of components installed per customer per year if he decides on the van rather than the 207Di. Both vehicles would be depreciated on a straight-line basis over 5 years for accounting and tax purposes. The company s cost of capital is 15% after tax. The taxation rate for the company is 29%. Use 20% per year on the straight line basis for section 11e purposes. Assume that all cash flows occur at the end of the year, unless otherwise stated. The planning horizon for this decision is 5 years. 6

Nkgato s estimates of the usage of the vehicles over the next 5 years are as follows: 2008 2009 2010 2011 2012 Km driven each year 20 000 30 000 40 000 50 000 50 000 Diesel per litre R7.50 R8.00 R9.00 R9.00 R9.00 # components installed (with 207Di) 40 45 50 55 55 # components installed (with van) 45 50 57 62 62 Average income per component R3 500 R4 000 R5 000 R5 000 R6 000 a) Briefly discuss the applicability of the payback and accounting rate of return methods to Nkgato s decision. Support your answer with calculations where possible. 7

QUESTION 4 SOURCE: YEAR TEST 3 (2009) X (PTY) LIMITED The management of X (PTY) LIMITED is at present considering acquiring one of the following two machines, which will fully satisfy the manufacturing requirements of the Brooklyn plant: Machine A Machine B Cost price R 100 000 R 100 000 Residual value at the end of its useful life R 20 000 R50 000 Useful life of machine 5 years 4 years Depreciation rate 20 % 20 % Depreciation method Straight line method Diminishing balance method Expected before-tax operating cash profit to be realised in year 1 attributable to the R102 000 R90 000 utilisation of the machine Estimated contribution ratio in year 1 90 % 95 % Estimated net operating profit (before depreciation) to sales ratio in year 1 85 % 80 % Expected change in sales volume per year 10 % increase 10 % increase Expected change in fixed cost per year 4 % increase 4 % increase Taxation wear-and-tear allowance (Straight line basis) Additional information: 20 % per annum (second hand machine) 40 % per annum (year 1) 20 % per annum (year 2-4) 1. No other changes in cost or volume (other than those indicated above) are anticipated. 2. The company s after-tax weighted average cost of capital amounts to 15% per annum. 3. A tax rate of 30% per annum will be applicable. Tax will paid at the end of the year in which it is incurred. 4. You may assume that the company has sufficient taxable income from other projects to absorb any assessed losses that may arise from the machines under consideration. Round off all answers to the nearest rand. a) Briefly describe, in your own words, the meaning of the term weighted average cost of capital. b) Assuming that the decision between machine A and B is mutually exclusive given the capital resources available for investment are limited to R100 000: i) Calculate the net present value of the expected future cash flows of Machines A and B. ii) Briefly conclude (with reasons) which machine (A or B) should be acquired. c) Assume now that X (Pty) Limited has sufficient funds to invest in both machines. Indicate (with reasons) whether the conclusion reached in (b) above, would be influenced by this. 8

QUESTION 5 SOURCE: YEAR TEST 3 (2011) FLYING DOG ALE Johannes van Schoor was recently appointed as the innovation manager at Take It To Task (Pty) Ltd. The company has been set up to identify successful trends oversees and based on project viability implementing them in South Africa. One of the projects that the company identified upon start-up was a microbrewery. The project has been allocated to Johannes who is very excited to make a great first impression. The company has analysed trends from the USA and Australia and believes that the South African microbrewery market is about to take off due to a lack of innovation and new brands. Initial research has indicated that management has insufficient knowledge to take the project on without a specialist and as such has approached a very successful microbrewery in the USA, Flying Dog Ale. Flying Dog Ale is very popular among young beer drinkers as it is seen as the cool beer brand. Flying Dog Ale has provided a road map of setting up the brewery in South Africa. This information is tabled below and offers the company 2 different ( mutually exclusive) options: Option 1 New machine Option 2 Second Hand Machine Acquisition date 1 November 2011 1 November 2011 Cost price R 10 000 000 R 2 500 000 Refurbishment costs tax deductible in first - R 400 000 year Useful life of equipment 6 years 3 years Residual value at end of 3 years R 2 500 000 R 300 000 Residual value at end of 6 years R 500 000 Not applicable Maintenance costs Included in purchase price for first 3 years R 600 000 (10 % increase per annum) Capital allowances 40%; 20%; 20%; 20% 20 % per annum Annual production 1 000 000 litres 550 000 litres Selling price per bottle (with 10% increase p.a.) R 12.00 R 12.50 Direct costs per bottle R 6.50 R 6.50 Annual fixed costs (5 % increase in total p.a.) R 500 000 Note1 R 300 000 Note1 Royalties payable to Flying Dog Ale Company See table below See table below Note 1: The non-cash amounts included in the total annual fixed cost amount to R120 000 per annum (unchanged) for each of the 6 years for option 1 and R80 000 per annum (unchanged) for each of the 3 years for option 2. Flying Dog Ale has indicated that royalties are payable at the end of each year based on the following table: First 500 000 litres per annum: 1% of total turnover value of 500 000 litres For every additional 250 000 litres (or part thereof) R25 000 9

ADDITIONAL INFORMATION: 1. Revenue estimates are based on production. Johannes believes that the company can sell whatever it produces but the directors are not so optimistic. The reason for the change in selling price per litre is to encourage sales at higher volumes. As such Johannes has been told that the company will review the project after three years to decide on its viability. 2. Due to the high popularity of 750ml (quart) bottles in South Africa, Johannes believes the company should take the next step and sell the beer in 1 litre bottles. It is expected that based on its popularity the sales prices (as stated above) will increase by 10% per every year. Johannes has negotiated contracts with suppliers that will ensure that direct costs per bottle will remain consistent for the next 3 years. 3. The company s cost of capital is 18% after tax. The prevailing tax rate is 28% and there is no indication that this will change for the foreseeable future. You can assume that all cash flows take place at the end of each year unless otherwise specified. 4. You may assume that the company has sufficient taxable income on other projects each year to absorb any tax losses that may arise in any of the years for the projects under consideration. 5. As capital is hard to come by for the company the directors require a repayment period of 2 years. a) Determine the net present value of: i.) Option 1, the new machine based on the first three years data only; and ii.) Option 2, the second-hand machine. b) Indicate what concerns you would have regarding a comparison of the two options and indicate which of the two options, supported with an appropriate argument, you would advise the company to take. c) Determine the repayment period of the project under both options and advise the company which option should be selected on this basis. 10

QUESTION 6 SOURCE: EXAM (2010) THE QUESTION CONSISTS OF TWO INDEPENDENT PARTS. LUXURY VEHICLES (PTY) LIMITED Luxury Vehicles (Pty) Limited is a newly incorporated company that will hire out luxury vehicles to corporate clients from 1 January 2011. Management is in the process of determining the all-inclusive daily rental rate that will be charged in respect of their BMW 1series vehicles. Management has indicated that they intend to charge a single allinclusive daily rental rate that will result in them being in the same cash position as their competitors. In Part A of this question, management is looking specifically at the information of a competitor, namely Lavish Vehicles (Pty) Limited, to gain information for their own purposes. In Part B of this question, the information specific to Luxury Vehicles (Pty) Limited will be addressed. Note the following will apply to both companies: The South African Revenue Service (SARS) allows an annual 20% taxation deduction in respect of vehicles. You may assume that all income is taxable and all expenses tax deductible. A tax rate of 30% per annum will apply. Tax will paid at the end of the year in which it is incurred. The cash flows of both companies will be evaluated using an after-tax cost of capital of 15 % per annum. You may also assume that all cash flows will occur at the end of the year (unless otherwise indicated). PART A LAVISH VEHICLES (PTY) LIMITED In order to determine a market-related daily rental rate, management obtained the following cash budget of its main competitor. The cash budget that reflects the cash in- and outflows attributable to a BMW 1series vehicle that will be hired out by Lavish Vehicles (Pty) Limited from 1 January 2011: Cash budget for the year ended 31 December 2011 Notes Rand Cost price of vehicle (R 650 000) - Acquisition date: 1 January 2011 - Useful life of vehicle: 5 years - Residual value at end of useful life: 40 % of original cost price Rental income 1 R 258 400 Cost of fuel 2 (R 10 200) Service cost 3 (R 0) Tax paid (R 35 460) R 437 260 11

Notes 1. Lavish (Pty) Limited charges a fixed daily rental fee as well as a fee per kilometre travelled each day. The following example of their fee structure appears on their invoices: Average kilometres travelled per rental vehicle per day Total rental income per rental vehicle per day 100 km R 2 470 200 km R 3 040 The management of Lavish (Pty) Limited prepared their cash budget on the assumption that the vehicle would be rented for 100 days during the financial year. They expect the numbers of days rented per annum to increase by 10 % at the end of every two years (i.e. the start of the 3 rd, 5 th year etc), whereas the average kilometres travelled per rental vehicle per day will remain constant. 2. The vehicle has a fuel efficiency of 10 km/l. The company has contracted with the fuel supplier to purchase fuel for a 5 year period at the fixed price of R 8.50 per l (the premium in fuel price is paid to account for all possible adverse price increases that may occur during this period). Accordingly, Lavish (Pty) Limited does not intend increasing their rate per kilometre charged to customers. 3. The vehicle will be serviced comprehensively every 50 000 kilometres. It currently costs R 10 000 to service a vehicle and the cost is expected to increase by 10% at the end of every year. a) Calculate, in respect of only one vehicle, the fixed daily rental fee charged and the fee charged per kilometre travelled per day by Lavish (Pty) Limited. b) Calculate the average kilometres travelled per day as used to the prepare the cash budget of Lavish (Pty) Limited. c) Calculate the net-present value of the future cash flows attributable to Lavish (Pty) Limited s BMW 1series vehicle. PART B LUXURY VEHICLES (PTY) LIMITED The management of Luxury Vehicles (Pty) Limited determined the after tax net-present value of future cash outflows (i.e. exclusive of the all-inclusive daily rental fee), in respect of one of their BMW 1series vehicles to be hired out from 1 January 2011 to be an ouflow of R395 000. This value is based on the same principles applied in PART A. Assume the following: i. Both companies have the same number of vehicles in total. ii. Luxury s BMW 1series vehicles have a useful life of 5 years. iii. The net-present value per BMW 1series for Lavish (Pty) Limited (as determined in PART A) amounts to R 190 000. (Note that this is an assumed amount and not the actual answer for part A) iv. Luxury (Pty) Limited will hire out each BMW 1series for 100 days per annum throughout its useful life. 12

Propose an average single all-inclusive daily rental fee (before tax) that should be charged by Luxury Vehicles (Pty) Limited per rental vehicle that will place them in the same cash position as that of Lavish (Pty) Limited. 13