How often Capital investment and budgeting is asked

Where it was asked

• May/Jun 202226 marks
• May/Jun 201826 marks
• May/Jun 201522 marks

The questions

1. May/Jun 2022, Q4.121 marks

   Proudly South African (Pty) Limited is a textile manufacturing company that is considering expanding its sales into other regions. To achieve this, it needs to increase its manufacturing capacity by purchasing an additional fabric manufacturing machine, and management must choose between two options, COOL and SUPER. For COOL: cost price R3 500 000; working capital required R100 000; net operating income before tax R450 000; realisable value at end of useful life R488 000; useful life 5 years. For SUPER: cost price R3 880 000; working capital required R150 000; net operating income before tax R595 000; realisable value at end of useful life R560 000; useful life 5 years. Additional information: (1) depreciation has already been taken into account in determining net operating income, and is calculated with reference to the realisable value; (2) management expects the estimated net income before tax of COOL to increase in year 4 by R170 000 (based on year 3) and in year 5 by a further R230 000 (also based on year 3); (3) the current tax rate is 28% and is expected to remain unchanged over the useful life; (4) wear and tear allowances are calculated on the straight-line method at 25% per annum on the cost of the asset; (5) management requires an after-tax return of 16% per annum on capital projects of this nature; (6) all cash flows, except the initial capital outlays (which occur at the beginning of the year), occur at the end of the relevant financial year; (7) the present value of the cash flows of SUPER has already been calculated as R3 991 076; (8) the net present value (NPV) of COOL at 18% has already been correctly calculated as -R238 764 (shown as a negative figure, e.g. (R238 764)); and (9) the internal rate of return (IRR) of SUPER has already been correctly calculated as 15,63%. For Proudly South African (Pty) Limited's machine COOL, determine the internal rate of return (IRR) by interpolating between 15% and 18%. You must first show all detailed calculations of how the net present value (NPV) of machine COOL is determined, and thereafter show the interpolation calculation between 15% and 18% used to arrive at the IRR of machine COOL. Work to four decimal places and round off all other calculations to the nearest rand.

2. May/Jun 2022, Q4.22 marks

   Proudly South African (Pty) Limited is a textile manufacturing company that is considering expanding its sales into other regions. To achieve this, it needs to increase its manufacturing capacity by purchasing an additional fabric manufacturing machine, and management must choose between two options, COOL and SUPER. For COOL: cost price R3 500 000; working capital required R100 000; net operating income before tax R450 000; realisable value at end of useful life R488 000; useful life 5 years. For SUPER: cost price R3 880 000; working capital required R150 000; net operating income before tax R595 000; realisable value at end of useful life R560 000; useful life 5 years. Additional information: (1) depreciation has already been taken into account in determining net operating income, and is calculated with reference to the realisable value; (2) management expects the estimated net income before tax of COOL to increase in year 4 by R170 000 (based on year 3) and in year 5 by a further R230 000 (also based on year 3); (3) the current tax rate is 28% and is expected to remain unchanged over the useful life; (4) wear and tear allowances are calculated on the straight-line method at 25% per annum on the cost of the asset; (5) management requires an after-tax return of 16% per annum on capital projects of this nature; (6) all cash flows, except the initial capital outlays (which occur at the beginning of the year), occur at the end of the relevant financial year; (7) the present value of the cash flows of SUPER has already been calculated as R3 991 076; (8) the net present value (NPV) of COOL at 18% has already been correctly calculated as -R238 764 (shown as a negative figure, e.g. (R238 764)); and (9) the internal rate of return (IRR) of SUPER has already been correctly calculated as 15,63%. Based on a comparison of the internal rates of return (IRR) of the two machines, COOL and SUPER, make a recommendation to Proudly South African (Pty) Limited's management as to which machine should be acquired, and provide a motivation for this recommendation.

3. May/Jun 2022, Q4.33 marks

   Proudly South African (Pty) Limited is a textile manufacturing company that is considering expanding its sales into other regions. To achieve this, it needs to increase its manufacturing capacity by purchasing an additional fabric manufacturing machine, and management must choose between two options, COOL and SUPER. For COOL: cost price R3 500 000; working capital required R100 000; net operating income before tax R450 000; realisable value at end of useful life R488 000; useful life 5 years. For SUPER: cost price R3 880 000; working capital required R150 000; net operating income before tax R595 000; realisable value at end of useful life R560 000; useful life 5 years. Additional information: (1) depreciation has already been taken into account in determining net operating income, and is calculated with reference to the realisable value; (2) management expects the estimated net income before tax of COOL to increase in year 4 by R170 000 (based on year 3) and in year 5 by a further R230 000 (also based on year 3); (3) the current tax rate is 28% and is expected to remain unchanged over the useful life; (4) wear and tear allowances are calculated on the straight-line method at 25% per annum on the cost of the asset; (5) management requires an after-tax return of 16% per annum on capital projects of this nature; (6) all cash flows, except the initial capital outlays (which occur at the beginning of the year), occur at the end of the relevant financial year; (7) the present value of the cash flows of SUPER has already been calculated as R3 991 076; (8) the net present value (NPV) of COOL at 18% has already been correctly calculated as -R238 764 (shown as a negative figure, e.g. (R238 764)); and (9) the internal rate of return (IRR) of SUPER has already been correctly calculated as 15,63%. List three risks or three uncertainties that are inherent in capital budgeting decisions. You are not required to distinguish between which of these are risks and which are uncertainties.

4. May/Jun 2018, Q4(a)15 marks

   Pro-ball Limited is a specialist manufacturer of balls for various sports, including netball, soccer and rugby, and currently uses an existing cutting-and-stitching machine to make soccer balls. A new, improved cutting-and-stitching machine for soccer-ball production was unveiled at an international sporting-equipment fair held in Berlin, Germany, and is expected to have 15% more production capacity than the existing machine over the useful life of the new machine. Details of the two machines are as follows: the existing machine cost R1 320 000 (no fair-attendance cost applies to it) while the new improved machine cost R1 800 000 plus R35 000 incurred to attend the international fair; the existing machine has a current book value of R792 000, a current tax value of R660 000 and a current market value of R600 000, while the new machine has none of these (being newly acquired); the realisable value at the end of its useful life is nil for the existing machine and R500 000 for the new machine; the existing machine had an initial useful life of 5 years with 3 years remaining, while the new machine has a useful life of 3 years; the maximum annual production and sales capacity (in batches) is 5 600 for the existing machine and 6 440 for the new machine. Expected economic conditions over the three remaining years are as follows - Year 1: selling price per batch R6 000, direct material cost per batch R2 000, variable manufacturing cost per batch R2 520, fixed costs per year (excluding depreciation) R850 000; Year 2: selling price per batch R6 600, direct material cost per batch R2 200, variable manufacturing cost per batch R2 772, fixed costs per year R901 000; Year 3: selling price per batch R7 260, direct material cost per batch R2 420, variable manufacturing cost per batch R3 049, fixed costs per year R955 000. Additional information: (1) annual production and sales for both machines will be limited to the maximum annual production capacity (in batches), and the economic climate is such that the maximum annual production is expected to be sold in full; (2) the annual wear-and-tear allowance for tax purposes is calculated on the straight-line method at 25% per annum on the cost of the asset; (3) depreciation is calculated over the useful life of the asset, taking the realisable value into account; (4) the current company tax rate is 28% and value-added tax (VAT) may be ignored; (5) management requires an after-tax return of 16% on capital projects of this nature; (6) all cash flows, except the initial capital outlay (which occurs at the beginning of the year), are assumed to occur at the end of the year concerned; (7) the net present value (NPV) of the existing machine has already been correctly calculated as R12 733 375. Using the net present value method, calculate the net present value (NPV) of the new improved machine for Pro-ball Limited. Your answer must clearly show how you calculated the present value of the after-tax cash flows for each year and how these were combined to arrive at the overall NPV, using factors obtained from the interest-factor tables provided. Execute all calculations to the nearest rand and round all factors used to three decimal places.

5. May/Jun 2018, Q4(b)2 marks

   Pro-ball Limited is a specialist manufacturer of balls for various sports, including netball, soccer and rugby, and currently uses an existing cutting-and-stitching machine to make soccer balls. A new, improved cutting-and-stitching machine for soccer-ball production was unveiled at an international sporting-equipment fair held in Berlin, Germany, and is expected to have 15% more production capacity than the existing machine over the useful life of the new machine. Details of the two machines are as follows: the existing machine cost R1 320 000 (no fair-attendance cost applies to it) while the new improved machine cost R1 800 000 plus R35 000 incurred to attend the international fair; the existing machine has a current book value of R792 000, a current tax value of R660 000 and a current market value of R600 000, while the new machine has none of these (being newly acquired); the realisable value at the end of its useful life is nil for the existing machine and R500 000 for the new machine; the existing machine had an initial useful life of 5 years with 3 years remaining, while the new machine has a useful life of 3 years; the maximum annual production and sales capacity (in batches) is 5 600 for the existing machine and 6 440 for the new machine. Expected economic conditions over the three remaining years are as follows - Year 1: selling price per batch R6 000, direct material cost per batch R2 000, variable manufacturing cost per batch R2 520, fixed costs per year (excluding depreciation) R850 000; Year 2: selling price per batch R6 600, direct material cost per batch R2 200, variable manufacturing cost per batch R2 772, fixed costs per year R901 000; Year 3: selling price per batch R7 260, direct material cost per batch R2 420, variable manufacturing cost per batch R3 049, fixed costs per year R955 000. Additional information: (1) annual production and sales for both machines will be limited to the maximum annual production capacity (in batches), and the economic climate is such that the maximum annual production is expected to be sold in full; (2) the annual wear-and-tear allowance for tax purposes is calculated on the straight-line method at 25% per annum on the cost of the asset; (3) depreciation is calculated over the useful life of the asset, taking the realisable value into account; (4) the current company tax rate is 28% and value-added tax (VAT) may be ignored; (5) management requires an after-tax return of 16% on capital projects of this nature; (6) all cash flows, except the initial capital outlay (which occurs at the beginning of the year), are assumed to occur at the end of the year concerned; (7) the net present value (NPV) of the existing machine has already been correctly calculated as R12 733 375. Based on your net present value calculations for Pro-ball Limited, advise whether the existing cutting-and-stitching machine should be replaced with the new improved machine, motivating your recommendation.