The board of directors of the Kalama Power Corporation has decided that for the purpose of testing whether its capital investment projects are acceptable, a compound interest (DCF) rate of 8% per annum will be used in evaluating investment projects.
All investment projects are now under consideration. Estimates of the expected cash flows over forty years are as follows:
|
Expected cash flows during each year
|
|
Years
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Net receipts
Sh. Million
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Net payments
Sh. Million
|
|
1 - 5
6 - 10
11 - 20
21 - 40
|
-
1,500
800
400
|
2,000
-
-
-
|
The expected residual value of the assets is zero.
Required:
(a) Show whether the project satisfies the normal capital budgeting criteria for acceptance.
(b) Show how sensitive the calculation in (a) above is to:
(i) An increase in the residual asset value from zero to sh.1,000,000.
(ii) A 1% increase in the initial capital outlay (during each year of the outlay).
A 1% decrease in the estimate of expected cash flow during each
of the years from 6 to 10.
(c) Show the effect of adopting the project on the ratio of reported profits in years 5 and 6 to net balance sheet value of assets at the beginning of those two years. Comment briefly on the usefulness of the latter type of ratio in the interpretation of accounts in the light of your calculation. (Assume that the expenditure in years 1 to 5 is capitalized, that straight-line depreciation is charged after year 5 at 5% per annum, and the actual cash flows are according to plan).
You can assume that all cash flows arise on the last day of each year, that all figures are net of tax and expressed in terms of constant price levels, and that working capital for the investment project can be ignored.