Illustration 1 New project case

Omo Enterprise, a new firm is considering a small scare capital project about which the
following information is available.
1. The investment out lay on the project will be birr 100 million.
This consists of birr 80 million on plant and machinery and birr 20 million on net
working capital .The entire out lay will be incurred at the beginning ( first year) of
the project.
2. The project will be financed with birr 45 million of equity capital, birr 5 million
of preference capital, and the rest with debt capital. Preference capital will carry a
dividend rate of 10% debt capital will carry an interest rate of 8% assume that the
weighted average cost of capital for the firm is 12%.
3. The life of the project is expected to be 5 years. At the end of the 5th year, fixed
assets will be disposed at ante proceeds of birr 30 million where as net working
capital will liquidate at its book value.
4. The project is expected to generate revenues of birr 120 million annually. Costs
and expenses other than depreciation and interest would be birr 80 million per
year. The effective tax rate will be 30%
5. In computing depreciation, a rate of 25% on the declining balance of plant &
machinery will be used per year.

Required
1. Judge whether the capital project of Omo Enterprise would financially be feasible
using the NPV criteria.
2. Compute the following:
a) IRR and decide to accept or reject.
b) Profitability Index
c) Pay back period
d) Discounted pay back period
e) Average accounting rate of return (ARR)

Illustration 2 – Expansion project case

Adigrate Parma Ltd. is engaged in the manufacture of pharmaceuticals. The company

was established in 1988 E.C and has registered a steady growth in sales since then.
Presently the company manufactures 16 products. Currently, the company is considering
the manufacture of a new antibiotic preparation, which is named item K, for which the
following information has been gathered:
1. Item K is expected to have a product life cycle of five years and there after it
would be withdrawn from the market.
The sales from this product are expected to be as follows:

Year sales (in millions)

1 birr 100
2 150

1
 3 200
4 150
5 100

2. The capital equipment required for manufacturing item K is birr 100 million and it
will be depreciated at the rate of 25 % per year which is applied on the declining
balance for tax purposes. The expected net salvage value after five years is birr 20
million.
3. The working capital requirement for the project is expected to be 20% of sales. At the
end of 5 years, working capital is expected to be liquidated at book value barring on
estimated loss of birr 5 million on account of bad debt. The bad debt loss will be tax for
deductible expense.
4. The accountant of the firm has provided the following cost estimates for item K:
Raw material cost----------------------------------------------- 30% of sales
Variable labor cost--------------------------------------------20% of sales
Fixed annual operating and
Maintenance cost-------------------------------------------birr 5 million
Overhead allocation (excluding
Depreciation, maintenance, and interest) ----------------10% of sales
While the project is charged an overhead allocation for being part of the overall
company, it is not likely to have any effect on the existing overhead costs & expenses of
the firm
5. The manufacture of item K would also require some of the common facilities of the
Firm. The use of these facilities would call for reduction in the production of other
Pharmaceutical preparations of the firm. This would entail a reduction of birr 15
million of contribution margin annually.
6. The tax rate applicable to the firm is 40% and its cost of capital is 12%.
7. Assume that the level of working capital is adjusted at the beginning of the year in
relation to the expected sales for the year.

Required: Identify the relevant cash flow of the expansion project and decide whether it
is worthwhile to undertake the expansion project.

Illustration 3 Replacement project case

Awassa Textile share co requires your help in determining the cash flow for a project
involving replacement of an old machine by a new machine. The old machine bought a
few years ago has a book value of birr 400,000 and it can be sold at an ordinary gain of
birr 166,667 an disposal. The gain is tax deductible.
The old machine has a remaining life of five years after which its net salvage value is
expected to be birr 160,000. The machine is being depreciated annually at a rate of 25%
which is applied on the declining book value of the asset. The working capital required
for the old machine is birr 400,000.
The new machine costs birr 1,600,000. It is expected to fetch a net salvage proceed of
birr 800,000 after 5 years when it will no longer be required. The depreciation method
will be the same as the one applied on the old machine.

2
The net working capital required for the new machine is birr 500,000 Replacement of the
old machine is expected to bring a saving of birr 300,000 annually in manufacturing costs
(other than depreciation). The tax rate applicable to firm is 40%` and a 12% discount rate.

Required.

1. Given the above information, decide whether to replace the old machine or not.
2. Show the net benefit or net cost of your decision.

Illustration 4 Replacement project case

Assume that a firm contemplates to replace an existing plant asset with a new one in
order to increase the operating efficiency of the manufacturing process. The following
data is available for the old asset & the new one.

New Asset
Old Asset
Original cost = br. 100,000 Original cost = br 200,000
Remaining economic life 5 years Remaining economic life = 5 years
Annual depreciation(SLM) 10,000 Annual depreciation =35,000
Estimated savage value 0 Estimated savage value =br25, 000
Annual operating cost br 40,000 Annual operating cost = br 10,000

Tax rate applicable to the firm 40%

Replacement of the asset does not affect the working capital requirement.
The firm’s cost of capital is 7%

Required

Determine whether to replace the asset or not assuming that the current salvage proceeds
on sale of the old asset would be:

a) birr 60,000
b) birr 30,000