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Business Finance Decision Suggested Solution Test # 2: Answer - 1

This document provides an analysis and solution to a business finance decision test question. It examines the purchase of £1.2 million in equipment by calculating: [1] The net present value of cash flows over 4 years is positive at £149,493. [2] A sensitivity analysis shows annual sales would need to be 9.53% lower than estimated for the investment to not be worthwhile. [3] Sale proceeds could fall 42% from the estimated £620,000 before the net present value became negative. Therefore, the equipment purchase should be made as it increases shareholder wealth.

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Syed Muhammad Kazim Raza
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126 views

Business Finance Decision Suggested Solution Test # 2: Answer - 1

This document provides an analysis and solution to a business finance decision test question. It examines the purchase of £1.2 million in equipment by calculating: [1] The net present value of cash flows over 4 years is positive at £149,493. [2] A sensitivity analysis shows annual sales would need to be 9.53% lower than estimated for the investment to not be worthwhile. [3] Sale proceeds could fall 42% from the estimated £620,000 before the net present value became negative. Therefore, the equipment purchase should be made as it increases shareholder wealth.

Uploaded by

Syed Muhammad Kazim Raza
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Business Finance Decision

Suggested Solution
Test # 2

Answer - 1

(a)
t0 t1 t2 t3
£'000 £'000 £'000 £'000
Equipment (1,200.000) 620.000
Tax on Cap. Allowances (W1) 67.200 53.760 43.008 (1.568)
Sales (W2) 3,520.000 3,520.000
Variable costs (W2) (2,200.000) (2,200.000)
Fixed costs (W3) (355.000) (355.000) (355.000)
Rent (80.000) (80.000) (80.000)
Tax on extra profit (W4) 22.400 121.800 (247.800) (270.200)
Working Capital (340.000) (10.000) 350.000
Total cash flows (1,190.400) (599.440) 670.208 1,663.232
8% discount 1.000 0.926 0.857 0.794
PV (1,190.400) (555.081) 574.368 1,320.606
NPV 149.493

The NPV is positive and so the equipment should be purchased as GV’s shareholder wealth will
increase.
WORKING

(1) t0 t1 t2 t3
£'000 £'000 £'000 £'000
Cost/WDV b/f 1,200.000 960.000 768.000 614.400
WDA @ 20% (240.000) (192.000) (153.600) 5.600
WDV/sale 960.000 768.000 614.400 620.000

Tax on WDA @ 28% 67.200 53.760 43.008 (1.568)


(2) Annual sales value 88,000 x £40 = 3,520,000
Annual variable costs 88,000 x £25 = 2,200,000

(3)

Fixed costs per question £660,000


Less: Bank interest (92,000)
Head Office allocation (68,000)
Depreciation charge ([£1,200,000-£620,000]/4) (145,000)
Relevant Fixed Costs 355,000

(4)
t0 t1 t2 t3
£'000 £'000 £'000 £'000
Sales 3,520.000 3,520.000
Variable costs (2,200.000) (2,200.000)
Fixed costs (355.000) (355.000) (355.000)
Rent (80.000) (80.000) (80.000) 0
Extra profit/(loss) (80.000) (435.000) 885.000 965.000

Tax on extra profit @28% 22.400 121.800 (247.800) (270.200)


(b) (i) Sensitivity of annual sales
Total current annual contribution ([£40 - £25] x 88,000) £1,320,000
Less: tax at 28% (369,600)
950,400
Total discount factor for T2 and T3 (0.857 + 0.794) x 1.651
PV generated from contribution £1,569,110

Net present value of scheme £149,493

Sensitivity of annual sales £149,493/£1,569,110 9.53%


(88,000 x 9.53%) 8,386 units
Break-even level of annual sales (88,000 – 8,386) 79,614 units

Annual sales volume is fairly sensitive – a 9.5% overestimation of the expected sales would
mean that the investment is in fact not worthwhile.

(ii) Sensitivity of sales proceeds


Let X be the fall in the resale value (and, therefore, the rise in the balancing allowance)
(X x 0.794) – (X x 0.28 x 0.794) = £149,493
0.794X – 0.22232X = £149,493
0.57168X = £149,493
X = £261,498
So the resale value can fall to (£620,000 – £261,498) = £358,502 (42%)

The sale proceeds of the equipment are not very sensitive. Estimated proceeds would have to fall by 42% before the NPV
Became negative.

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