“A” LEVEL ACCOUNTING

CAPITAL BUDGETING

REVISION QUESTIONS

BOOKLET

Tinofamba nevanofamba

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 QUESTION 1

Randal Ltd is considering expanding its business and has to decide between taking on Project
A or Project B. Both projects have a life of four years. Equipment is expected to have no
scrap value.

Other information about the projects is as follows:

Project A Project B
$ $
Initial cost $150 000 $ 140 000
Annual sales $100 000 $ 120 000
Annual purchases $40 000 $65 000
Other costs as a percentage of sales 8% 5%
Increase in working capital $10 000 $18 000

Randal Ltd uses a cost of capital of 10%. Discounting factors at 10% are as follows :

Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683

Using a cost of capital of 10% Project B has a net present value of $15 281.

REQUIRED
a. For each of the two projects calculate the following :
i. The annual net cash flow
ii. The Accounting Rate of Return
iii. The Payback period
b. Calculate the Net Present Value for Project A only.
c. State two benefits and two drawbacks of each of the following.
i. Accounting Rate of Return.
ii. The Payback period.
iii. The Net Present Value.
d. State which of the two projects Randal Ltd should select. Give reasons for your
answer.

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 QUESTION 2
Two years ago Sandstone Ltd conducted market research at a cost of $16 000 to investigate
the potential market for new products. They are now considering two new products
developments, only one of which will be undertaken. The anticipated profitabilities of these
two separate projects are given below.

Project A Project B
$ $ $ $
Annual sales 80 000 100 000
Cost of sales 40 000 50 000
Administration costs 15 000 10 000
Depreciation 5 000 10 000
60 000 70 000
20 000 30 000

It is expected that the above will continue for each year of each project’s forecast life. The
capital cost for project A is $45 000 and for project B is $53 000.
The expected economic lives are
Project A 8 years
Project B 5 years
Depreciation has been calculated on a straight line basis, and assumes estimated scrap values
of $5 000 for Project A at the end of year 8, and $3 000 for Project B at the end of year 5.
All costs and revenue take place at the end of each year
The cost of capital is 12%
Extract from present value tables $1 @ 12%
Year 1 0,893 Year 5 0,567
Year 2 0,797 Year 6 0,507
Year 3 0,712 Year 7 0,452
Year 4 0,636 Year 8 0,404
REQUIRED

a. Calculate the payback period and net present value of each project (14 marks)
b. State, with reasoning, which of the two projects you would recommend (3 marks)
c. Briefly explain why net present value is considered a more meaningful technique
compared to payback when making capital expenditure decisions (4 marks)
d. Explain how you have treated the original market research costs in relation to the
evaluation of the projects. (2 marks)
( Total 23 marks)

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 QUESTION 3

Power High School hires a bus whenever it has to travel for sports. The School Development
Association is considering buying a school bus.

The cost of the new bus is $110 000 payable $50 000 now and the balance in twelve months
time. The bus is expected to run for five years, after which it will be sold for $10 000.

At the beginning of the first year, the costs of running the new bus per annum are currently:

$
Fuel 10 000
Repairs 5 000
Other costs 2 000

These costs are expected to increase by 10% for each of the next three years and thereafter by
5% each year.

The cost of hiring a bus is currently $800 per trip and the school has an average of 40 trips
per year. The cost is expected to increase by 20% each year for the next 2 years and by a
further 10% each year thereafter. The cost of capital is 10%. The following extract is from the
present value table for $1.

10%

Year 1 0.909
2 0.826
3 0.751
4 0.683
5 0.621

Required
a. The annual savings rounded off to the nearest dollar, to be made by running a new
bus. {6}
b. The Payback period {4}
c. The Net Present Value {12}
d. Advise the School Development Association (SDA) whether to buy or to continue
hiring. {3}

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 QUESTION 4

James Joyce Ltd has $1 000 000 to invest in a project. The company had to make a choice
between two projects and has been given the following information about them:

Project A Project B
$000 $000
Initial outlay 1000 1000
Expected cash inflows
Year 1 300 600
Year 2 400 400
Year 3 500 200
Year 4 530 200
Year 5 600 200

Cost of capital is estimated at 12%, and both projects are expected to have a residual
value of zero at the end of the five year period.

Further information is available in the form of discount factor tables giving the Net
Present Value of $1.

12% 16% 20% 24% 28% 32%

Year
1 0.893 0.862 0.833 0.806 0.781 0.758
2 0.797 0.743 0.694 0.650 0.610 0.574
3 0.712 0.641 0.579 0.524 0.477 0.435
4 0.636 0.552 0.482 0.423 0.373 0.329
5 0.567 0.476 0.402 0.341 0.291 0.250

Joyce book keeper has advised that Project B be accepted, as it has the fastest payback.

Required

a. Evaluate Projects A and B using

i. The Net Present Value
ii. The Internal Rate of Return
b. Explain the Payback method and state two advantages and two disadvantages of using
it.

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 QUESTION 5

The directors of Shumirai Ltd are considering expanding their company by investing in a
bigger investment that generate more profit. The directors have got two project proposal,
Project A and Project B. Project A costs $45 000 and Project B costs $50 000. However due
to shortage of funds, only one of the projects can be undertaken.

$ $
Project A Project B
Expected profit year 1 7 000 16 000
2 9 000 15 000
3 10 000 8 000
4 10 000 6 000
5 11 000 4 000

Estimated residual value at the end of 5 years 3 000 5 000

Additional information
1. The company’s cost of capital is 12%.
2. Profits as given above have been calculated after deducting straight line depreciation
calculated over 5 years.
3. The relevant discount tables are shown below:

12% 20%
End of year 1 0.893 0.833
2 0.797 0.694
3 0.712 0.579
4 0.636 0.482
5 0.567 0.402
Required
a) Calculate for each of the projects,
i) the payback period to the nearest month, {4}
ii) the net present value (NPV), {8}
iii) the internal rate of return {8}
b) Advise the directors which of the two projects it should undertake. Give reasons
for your choice. {5}

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