ACCA FM Syllabus D. Investment Appraisal - Capital rationing - Single period- Types - Past Papers ^{3 / 5}

Argnil Co is appraising the purchase of a new machine, costing $1·5 million, to replace an existing machine which is becoming out of date and which has no resale value. The forecast levels of production and sales for the goods produced by the new machine, which has a maximum capacity of 400,000 units per year, are as follows:

The new machine will incur fixed annual maintenance costs of $145,000 per year. Variable costs are expected to be $3·00 per unit and selling price is expected to be $5·65 per unit. These costs and selling price estimates are in current price terms and do not take account of general inflation, which is forecast to be 4·7% per year.

It is expected that the new machine will need replacing in four years’ time due to advances in technology. The resale value of the new machine is expected to be $200,000 at that time, in future value terms.

The purchase price of the new machine is payable at the start of the first year of the four-year life of the machine.

Working capital investment of $150,000 will already exist at the start of the four-year period, due to the operation of the existing machine. This investment in working capital is expected to increase in nominal terms in line with the general rate of inflation.

Argnil Co pays corporation tax one year in arrears at an annual rate of 27% and can claim 25% reducing balance tax-allowable depreciation on the purchase price of the new machine. The company has a real after-tax weighted average cost of capital of 6% and a nominal after-tax weighted average cost of capital of 11%.

Required:
(b) Discuss the reasons why investment finance may be limited, even when a company has attractive investment opportunities available to it. (5 marks)

The Board of OAP Co has decided to limit investment funds to $10 million for the next year and is preparing its capital budget. The company is considering five projects, as follows:

All five projects have a project life of four years. Projects A, B, C and D are divisible, and Projects B and D are mutually exclusive. All net present values are in nominal, after-tax terms.

Project E
This is a strategically important project which the Board of OAP Co have decided must be undertaken in order for the Company to remain competitive, regardless of its financial acceptability. Information relating to the future cash flows of this project is as follows:

These forecasts are before taking account of selling price inflation of 5•0% per year, variable cost inflation of 6•0% per year and fixed cost inflation of 3•5% per year. The fixed costs are incremental fixed costs which are associated with Project E. At the end of four years, machinery from the project will be sold for scrap with a value of $400,000. Tax allowable depreciation on the initial investment cost of Project E is available on a 25% reducing balance basis and OAP Co pays corporation tax of 28% per year, one year in arrears. A balancing charge or allowance is available at the end of the fourth year of operation.

OAP Co has a nominal after-tax cost of capital of 13% per year.

Required:

(c) Discuss the reasons why the Board of OAP Co may have decided to limit investment funds for the next year. (6 marks)   (25 marks)

Discuss the nature and causes of the problem of capital rationing in the context of investment appraisal, and explain how this problem can be overcome in reaching the optimal investment decision for a company.