Question

11 Wipe Question one (60%) FANGO Itd is now considering different investment options that will make the firm more profitable as well as taste the growth of the company. The financial management team has provided the following financial information relating to one of investment which is perceived to be profitable by most of the managers. i. Estimated cash flows Year 2 34 Expected Pre-tax operating cashflows (Tshs) 1,250,000 1,400.000 1,600,000 1,800,000 The investment will cost Tshs 5,400,000 payable immediately, including Tshs 600,000 for working capital and Tshs 400,000 for issue costs. Tshs 300,000 of issue costs is for equity, and Tshs 100,000 for debt. Issue costs are not tax allowable. The investment will be financed 50% equity, 50% debt which is believed to reflect its debt capacity. Expected company gearing after the investment will change to 60% equity, 40% debt by market values. The investment equity beta is 1.5. vi. Debt finance for the investment will be at 8% fixed rate debenture. vii. Capital allowances are at 25% per year on a reducing balance basis as per tax policies viii. The corporate tax rate is 30%. Tax is payable in the year that the taxable cash flow arises. x. The risk-free rate is 4% and the market return 10% for such investment. The after tax realizable value of the investment as a continuing operation is estimated to be 21.5 million (including working capital) at the end of year 4. xi. Working capital may be assumed to be constant during the four years. Required: a. Calculate the expected NPV and recommend on feasibility of the investment (30 marks). b. If the company anticipate the tax laws to change in which capital allowance for asset/investment of this nature to decline to 20% and tax rate to decline by 30%, examine the feasibility of the investment and recommend to the management of the company. (30 marks)

Answer 1

a. Calculation of NPV
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
Initial Investment	-5,400,000
Working Capital	-600,000
Issuance Cost	-400,000
Pre tax operating cashflows		1,250,000	1,400,000	1,600,000	1,800,000
Debt Interest (5400000*50%*8%)		-216,000	-216,000	-216,000	-216,000
Market return (5400000*50%*10%)		-270,000	-270,000	-270,000	-270,000
Working capital released					600,000
Before tax	-6,400,000	764,000	914,000	1,114,000	1,914,000
Tax @ (30%)		-229,200	-274,200	-334,200	-574,200
Tax credit on depreciation allowance		405,000	303,750	227,813	170,859
Realisable value of Inv (after tax)					1,500,000
Total	-6,400,000	939,800	943,550	1,007,613	3,010,659
PV factor @ 4%	1	0.96154	0.92456	0.88900	0.85480
PV of cashflows	-6,400,000	903,654	872,365	895,764	2,573,524	-1,154,693
NPV	-1,154,693	Project not viable as NPV is negative
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
Total Cost of asset	5,400,000
Depreciation @ 25% reducing balance		1,350,000	1,012,500	759,375	569,531
Tax credit @ 30%		405,000	303,750	227,813	170,859

b. Calculation of NPV
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
Initial Investment	-5,400,000
Working Capital	-600,000
Issuance Cost	-400,000
Pre tax operating cashflows		1,250,000	1,400,000	1,600,000	1,800,000
Debt Interest (5400000*50%*8%)		-216,000	-216,000	-216,000	-216,000
Market return (5400000*50%*10%)		-270,000	-270,000	-270,000	-270,000
Working capital released					600,000
Before tax	-6,400,000	764,000	914,000	1,114,000	1,914,000
Tax @ (30%*70% = 21%)		-160,440	-191,940	-233,940	-401,940
Tax credit on depreciation allowance		226,800	181,440	145,152	116,122
Realisable value of Inv (after tax)					1,500,000
Total	-6,400,000	830,360	903,500	1,025,212	3,128,182
PV factor @ 4%	1	0.96154	0.92456	0.88900	0.85480
PV of cashflows	-6,400,000	798,423	835,337	911,410	2,673,983	-1,180,848
NPV	-1,180,848	Project not viable as NPV is negative
Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
Total Cost of asset	5,400,000
Depreciation @ 20% reducing balance		1,080,000	864,000	691,200	552,960
Tax credit @ 21%		226,800	181,440	145,152	116,121.60