Question

SECTIONA Q2. Answer all parts [total 20 marks] (a) What factors distinguish 'capital expenditure' from other types of expenditure within manufacturing organisations? Support your answer with THREE examples of typical capital expenditure projects. (3 marks) (b) A company has budgeted for a capital investment of £150,000. Only one project can be chosen for investment and the company must decide between three different investment proposals. The following information is provided Project C Project A £150000 4 years Project B Capital expenditure £150000 £150000 Expected life Scrap value 5 years £8000 3 years £15000 expected£10000 Cash flow - yr 1 Cash flow -yr 2 Cash flow - yr 3 Cash flow - yr 4 Cash flow -yr 5 52000 52000 52000 48000 42000 42000 42000 42000 42000 62000 62000 62000 Notes 1. Capital expenditure for all three projects would be incurred immediately 2. Taxation is to be ignored 3. The company estimates its cost of capital to be 15% (Table QA2) You are required to calculate for each project; (i) (ii) (ili) the net present value the internal rate of return the payback period (12 marks) (c) State the relative merits of the methods of investment appraisal in b(i-ii). (3 marks) (d) Which project, on balance, you would recommend for acceptance? Give your reasons. (2 marks) Note: Present value of £1 table is given at the end of the paper

Answer 1

Answer (a):

Capital expenditures are amount spent on long terms assets. Capital assets are assets which provides benefits for more than one year. Capital expenditures are distinguished from other types of expenditure. For example revenue expenditures are those expenditures which provide benefits for short period (less than a year) and are charged off to the Income Statement of the year.

Capital expenditures are also distinguished from other expenses since capital expenditures commits the firm over long terms and at times involve bigger investments, they need to be properly evaluated before being spent.

Answer (b)

(i)NPV, (ii) IRR and (iii) payback period of all three projects (Project A, Project B and Project C) are calculated and given below:

Answer (c):

Merits of Payback method:

1. It is simple to calculate

2. Its principle of evaluating projects based on how quickly one can recover initial investment works well for risky investments or investments in technology investments where obsolescence rate is high.  

Demerits of Payback method:

1. It does not consider time value of money

2. It does not consider cash flows after payback period.

Merits of NPV:

1. NPV provides net addition to shareholder value.

2. NPV uses time value of money

3. It factors in cash flows of entire duration of project

Demerits of NPV:

1. Project size(initial investment) is not considered. When capital is limited and projects have to be ranked for selection, it is essential that initial capital investments are factored in. In such circumstances, instead of NPV, Profitability Index has to be used.

Merits of IRR:

1. IRR gives % return on the original money invested.

2. IRR uses time value of money

3. It factors in cash flows of entire duration of project

Demerits of IRR:

1. In quite a few circumstances when cash flows are erratic one may find multiple IRRs of an investment.

2. IRR assumes reinvestment at the rate of IRR

Answer (d):

As only one is to be selected, Project A is recommended for acceptance.

Payback period: No cut off payback period is given. Project C has lowest payback period and Project A is next best.

NPV: Project B has negative NPV and hence has to be rejected. Both project A and C has positive NPV and are acceptable. Since initial investment is same and Project A has higher NPV than that of Project C, Project A is recommended.

IRR: Project B has IRR less than cost of capital and hence has to be rejected. Both project A and C have IRR greater than cost of capital and hence are acceptable. Since Project A has higher IRR than that of Project C, Project A is recommended.