Question

TULUI (LJMIRJ) QUESTION TWO Cando Limited is considering investing K40 million in equipment which will generate a net cash flow of K16 million per year for four years. The company is able to depreciate the equipment at a rate of 20% per year on a straight-line for tax purposes. The market value of the equipment a the end of the four years is expected to be K15 million. The difference between the market value and the equipment's tax value (cost less depreciation to date of sale) is termed a recoupment which in this case is subject to tax. The corporation tax is 28%. The company's cost of capital is 14%. (Hint: assume depreciation is allowable as deduction before computing tax and that the tax as an outflow from the cash flows at 28%) (a) What is the project's net present value? (b) What is the project's RR? (c) What is the project's payback (d) Is the project viable? Justify your decision. (8 marks) (7 marks) (5 marks) (5 marks) Total (25 marks)

Answer 1

a) Net present value

Year	1	2	3	4
EBITDA	16,000,000	16,000,000	16,000,000	16,000,000
(-) Depreciation	(8,000,000)	(8,000,000)	(8,000,000)	(8,000,000)
EBT	8,000,000	8,000,000	8,000,000	8,000,000
(-) Tax 28%	(2,240,000)	(2,240,000)	(2,240,000)	(2,240,000)
Net profit	5,760,000	5,760,000	5,760,000	5,760,000
(+) Depreciation	8,000,000	8,000,000	8,000,000	8,000,000
Profit from sale				5,040,000
Cashflow	13,760,000	13,760,000	13,760,000	18,800,000

Note : Depreciation = 20% of 40,000,000 = 8,000,000

Profit after tax from sale :

Cost of machine after 4 years = 40,000,000 - 32,000,000 = 8,000,000

Market value = 15,000,000

Profit = 15,000,000 - 8,000,000

=7,000,000

After tax = 7,000,000 × 28% = 5,040,000

Using financial calculator

Inputs: C0 = -40,000,000

C1 = 13,760,000. Frequency = 3

C2 = 18,800,000. Frequency = 1

I = 14%

Npv = compute

We get, Npv = 3,076,765.91

b) Calculate Irr

We use financial calculator to calculate Irr

Inputs: C0 = -40,000,000

C1 = 13,760,000. Frequency = 3

C2 = 18,800,000. Frequency = 1

IRR = compute

We get, IRR = 17.527%

c) Payback period

Year	Cashflow	Cumulative Cashflow
0	(40,000,000)	(40,000,000)
1	16,000,000	(24,000,000)
2	16,000,000	(8,000,000)
3	16,000,000	8,000,000
4	16,000,000	24,000,000

Payback period= full year until recovery + unrecovered cost at the beginning of last year/ cash flow during last year

= 2 + 8,000,000/16,000,000

= 2 + 0.5

= 2.5 years

D) The project is viable because the Npv and irr are positive . Also the payback period is less than the tenure of the project.