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Introduction to capital budgeting decisions

Unit: Financial Management

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August 2025

 1 Questions
Question 4c
​ ​ ​Talino Developers Ltd. is a manufacturer of bricks and concrete blocks. The company is considering replacing part of the current manual labour force by purchasing a small tractor with a forklift for use in loading bricks and concrete blocks. The purchase price of the tractor would be Sh.6,500,000. The tractor will have an economic useful life of 5 years but would require Sh.250,000 overhaul cost at the end of the third year. After 5 years, the tractor would be sold for Sh.1,500,000. 

The company estimates that it will cost Sh.2,000,000 per year to operate the tractor. However, the company will save Sh.1,500,000 annually on labour cost. Due to increase in handling efficiency, losses caused by breakages will be cut by Sh.2,500,000 per year. Sales will also go up by Sh.5,000,000 per year. The increase in sales level is expected to be maintained throughout the tractor’s useful life. 

The firm’s gross margin ratio is 40%, corporate tax rate is 30% and cost of capital is 12%. The firm provides for depreciation on a straight line basis. 

Required: 
Compute the net present value (NPV) of the project and advise on whether the tractor should be purchased.


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April 2025

 2 Questions
Question 3
​ ​​The management of Talatibu Industries Ltd. is reviewing the company’s capital investments. There are six projects under consideration as follows: 

Project A: 
Initial outlay: Sh.29 million. 
Projected returns are as follows:

Year
Project returns 
 (Sh.“million”)
1
8
2
12
3
10
4
6

The capital equipment purchased at the start of the project could be resold for Sh.5 million at the start of the fifth year. 

Project B: 
It would involve a current cash outlay of Sh.44 million on capital equipment and Sh.20 million on working capital. 
Projected returns are as follows: 

Year
Sales
Variable costs 
Contribution
Fixed cost
Profit
 Sh.“million” 
 Sh.“million” 
 Sh.“million” 
 Sh.“million” 
 Sh.“million” 
1
75
50
25
10
15
2
90
60
20
10
20
3
42
28
14
8
6

Fixed costs include an annual charge of Sh.4 million for depreciation. At the end of the third year, the working capital investment would be recovered and the equipment would be sold for Sh.5 million. 

Project C: 
It would involve a current cash outlay of Sh.50 million on equipment and Sh.15 million on working capital. The investment in working capital would be increased to Sh.21 million at the end of the first year. Annual cash profits would be Sh.18 million per year, at the end of which the investment in working capital would be recovered. 

Project D: 
It would involve an outlay of Sh.20 million immediately and a further outlay of Sh.20 million after one year. Cash profits thereafter would be as follows: 

Year
Profits
(Sh.“million”)
2
15
3
12
4-8
8 per annum 

Project E: 
This is a long-term project involving an immediate outlay of Sh.32 million and annual returns of Sh.4.5 million in perpetuity. 

Project F: 
This is a long-term project involving an immediate outlay of Sh.20 million and annual returns as follows: 

Year
Profits
(Sh.“million”)
1 - 5
5
 6 - 10
4
11 to perpetuity 
3

Additional information: 
1. The company discounts all projects of ten years duration or less at a cost of capital of 12% and all the other projects at a cost of 15%. 
2. Ignore taxation. 

Required: 
(a) Calculate the Net Present Value (NPV) of each project. 

(b) Using calculations in (a) above, advise on the projects to be undertaken. 

(c) Calculate the Internal Rate of Return (IRR) for Projects A, C and E. 


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Question 1b
​ ​ ​​Pivot Ltd. is considering raising an additional Sh.20 million to finance an expansion programme. The firm’s existing capital structure which is considered to be optimal is as follows:

Sh.“000”
Ordinary share capital 
100,000
Reserves 
50,000
16% debentures (Sh.1,000 par value) 
62,500
14% preference shares capital (Sh.20 per value)
37,500
250,000

Additional information: 
  1. The firm expects to generate Sh.4 million from retained earnings for this expansion programme. 
  2. Additional new ordinary shares will be issued at Sh.90 each subject to a floatation cost of Sh.10 per share. The most recent dividend paid by the company is Sh.4 per share. The firm’s dividends are expected to grow at the rate of 5% per annum in perpetuity. 
  3. The company will issue new 16% debentures at a price of Sh.1,100 with a floatation cost of Sh.5 per debenture. 
  4. New 14% preference shares will be issued at Sh.30 with a floatation cost of Sh.2 per share. 
  5. Corporation tax rate applicable is 30%. 

Required: 
(i) The cost of retained earnings. 

(ii) The cost of new ordinary share capital. 

(iii) The cost of new 16% debentures.

(iv) The cost of new preference shares. 

(v) The company’s weighted marginal cost of capital (WMCC). 


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December 2024

 4 Questions
Question 2b
​ ​ ​​Kugoh Ltd. is considering whether or not to purchase a new machinery on 15 December 2024. 

Additional information: 
  1. The machinery will cost Sh.4,000,000 and it would have a useful life of four years, after which it would be sold for Sh.500,000. 
  2. The machinery would attract tax allowable depreciation at the rate of 25% per annum on a reducing balance basis which could be claimed against taxable profits of the current year. 
  3. A balancing allowance or charge would arise on disposal. The tax rate is 30% per annum. Half of the tax is payable in the current year and the balance the following year in arrears. 
  4. The machinery would create annual cost savings of Sh.1,400,000. 
  5. The after tax cost of capital of Kugoh Ltd. is 8%. 
  6. Depreciation is first claimed against year zero profits. 
Required: 
(i) Compute the annual after tax cash flows associated with purchasing the machinery. 

(ii) Compute the net present value (NPV) of purchasing the machinery.


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Question 1b
​ ​ ​ ​ ​ ​​(i) In relation to capital budgeting decisions, explain the term “abandonment value”.

(ii) Magenty Ltd. has presented the following information relating to a project under consideration:

Year
Cash flows
Abandonment value 
Sh.“000” 
Sh.“000” 
0
(6000) 
-
1
3,000
6,000
2
2,800
5,000
3
2,500
4,000
4
2,000
-

The company’s cost of capital is 12%. 

Required: 
Using suitable computations, advise the management of Magenty Ltd. on when to abandon the project. 


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Question 2a
​​Outline FOUR applications of cost of capital to a firm


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Question 3c
​ ​​ Safari Ltd. is contemplating purchase of a motor van for their rental business activities. The firm expects that the investment in the motor van shall generate annual after tax cash benefits of Sh.300,000 and that they can sell it for Sh.150,000 after five years. All the monies for purchasing the van shall come from the firm’s savings which are currently earning an interest rate of 16% per annum after taxes. 

 Required: 
(i)
Compute the maximum price payable to acquire the van today (Time 0).
(ii)
Assuming that the firm is of good credit rating and that it chooses to borrow the funds instead of using its savings. The firm has two alternative financing options of raising the funds as provided below:
Option 1:
Finance Company:
The firm can borrow from a finance company which requires it to make five annual equal instalments of Sh.277,963.75 covering both principal and interest. 
Option 2:
Insurance Company:
The insurance company requires the firm to make a lumpsum payment of Sh.1,850,000 covering both principal and interest at the end of five years.

Required:
Using suitable computations, advise the management of the firm on the suitable financing option to apply. 

    


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August 2024

 1 Questions
Question 1c
​ ​​Zamole Ltd. is considering a project which requires an initial investment of Sh.156,000,000 in machinery. The machinery will last for four years after which it will have a scrap value of Sh.26,000,000. The additional investment in working capital will be Sh.19,500,000. The expected annual profits before depreciation are as follows:

Year
Sh.“000”
1.
58,500
2.
58,500
3.
52,000
4.
32,500

The company requires a minimum accounting rate of return of 15% from the projects of this type. 

Required: 
Determine the Accounting Rate of Return (ARR) and advise whether the project should be undertaken. 


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April 2024

 1 Questions
Question 3b
​ ​ ​​The directors of Bandala Ltd. are reviewing the options relating to a machine that is a key part of the company’s production process. 

Option 1: Replace the machine: 
The cost of the new machine would be Sh.1,000 million payable immediately. 

Maintenance cost would be payable at the end of each year of the project. 

The first maintenance payment for the new machine is Sh.51 million although this is expected to rise by 8% per year. 

Option 2: Overhaul the existing machine: 
The alternative to replacement is a complete overhaul of an existing machine, the cost of which would be Sh.650 million also payable immediately. This would be classified as capital expenditure. 

However, under this option, the annual maintenance cost will be higher at Sh.81 million in year 1, with expected annual increase of 11%. 

As the new machine is likely to reduce the variable costs, the contribution will be different depending on which machine is used. 

The contribution from each machine (excluding maintenance costs) is tabulated as follows, with the inflows of funds assumed to be at the end of each year:

Year
1
2
3
4
5
Contribution of new machine (Sh.“000”) 
310,000
330,000
380,000
420,000
440,000
Contribution of overhauled machine (Sh.“000”) 
260,000
300,000
310,000
320,000
320,000

The cost of capital is 12%. Ignore taxation. 

Required:
(i) Calculate the net present value (NPV) of each option. 

(ii) Estimate the internal rate of return (IRR) of each option. 

(iii) Interpret the result that you have obtained in (b) (i) and (b) (ii) above and recommend which alternative should be chosen. 


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December 2023

 1 Questions
Question 1b
​ ​ ​ ​ ​ ​ ​ ​​Mapema Ltd. is considering investing in one of the following two mutually exclusive projects. The relevant cash flows of each of the projects are as shown in the table below:

 Annual cash flows 
Project X Sh.“000”
Project Y Sh.“000”
Initial investment
57,750
55,500
Cash flows  Year

1
37,500
45,000
2
(16,500) 
12,000
3
30,000 
(6,000)
4
22,500
33,000
5
9,000
(15,000)
6
7,500
22,500

Additional information: 
1. The firm’s cost of capital is 15%. 
2. Cash flows accrue at the end of the year. 

Required: 
Compute the following for each project: 

(i) Discounted payback period. 

(ii) Modified internal rate of return (MIRR). 

(iii) Profitability index (PI).


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August 2023

 1 Questions
Question 2b
​ ​​Fila Ltd. is considering to purchase a new machine so as to improve its production process which is currently being undertaken manually. The machine costs Sh.13,950,000. The firm will incur installation cost of Sh.450,000. The machine will have an economic life of 6 years but will require an overhaul at the end of the fourth year. The overhaul will cost Sh.1,125,000. After six years, the machine could be disposed of for Sh.900,000. 

The company estimates that that it will cost Sh.2,100,000 per year to operate the new machine. The current manual production method costs Sh.5,250,000 per annum. In addition to reducing annual operating costs, the new machine will allow the company to increase production capacity by 120,000 units per annum. The company realises a contribution margin of Sh.45 per unit. 

Additional information: 
  1. The company applies straight-line method of depreciation. 
  2. Corporate tax rate is 30%. 
  3. Fila Ltd. requires 20% return an all investment. 

Required: 
Using the Net Present Value (NPV) project evaluation method, advise Fila Ltd. on whether or not to purchase the machine.


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April 2023

 1 Questions
Question 1b
​ ​ ​​Cipo Ltd. is evaluating an investment project which requires the importation of a new machine at a cost of Sh.3,700,000. The machine has a useful life of six years and a salvage value of sh.1,000,000. 

Additional information:
1.
The following additional costs would be incurred in relation to the machine: 
1.
Sh.
Modification cost
1,000,000
Import duty 
900,000
Installation cost 
375,000
Freight charges 
225,000
2.
The machine is expected to increase the company’s annual cash flow (before tax) as shown below: 
2.
Year
1
Sh.“000”
2
Sh.“000”
3
Sh.“000”
4
Sh.“000”
5
Sh.“000”
6
Sh.“000”
Increase in cash flow 
1,760
1,360
1,050
900
840
750
3.
The machine is to be fully depreciated over its useful life using the straight-line method.
4.
The corporate rate of tax is 30% while the cost of capital is 10%.
5.
The maximum acceptable payback period for the company for all capital project is four years.

Required: 
(i) Total initial cost.

(ii) Annual net cash flow. 

(iii) Payback period of the machine. 

(iv) Net present value (NPV) of the machine.

(v) Advise the company’s management on whether to import the machine based on your results in (b) (iii) and (b) (iv) above. 


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December 2022

 1 Questions
Question 3c
​ ​​Jawabu Ltd. is evaluating a project with an expected useful life of 6 years and the following characteristics: 

1. Fixed capital investment of Sh.4,000,000. 
2. The initial investment in net worth working capital is Sh.400,000. At the end of each year, net working capital must be increased so that the cumulative investment in net working capital is one-sixth of the next year projected sales. 
3. The fixed capital is depreciated on cost at the following rates: 30% in year 1, 35% in year 2, 20% in year 3, 10% in year 4, 5% in year 5 and 0% in year 
4. Sales are Sh.2,400,000 in year 1, they grow at 25% annual rate for the next two years and then grow at 10% annual rate for the last three years. 
5. Fixed cash operating expenses are Sh.300,000 for year 1-3 and Sh.260,000 for year 4-6. 
6. Variable cash operating expenses are 40% of sales in year 1, 39% of sales in year 2 and 38% of sales in year 3 - 6. 
7. The corporate tax rate is 30%. If taxable income on the project is negative in any year, the loss will offset gains elsewhere in the corporation, resulting in a tax savings. 
8. Fixed capital investment will be sold for Sh.300,000 when the project is complete and recapture its cumulative investment in networking capital. Income taxes will be paid on any gains on disposal. 
9. The project required rate of return is 12%. 

Required: 
Determine the suitability of the project using the Net Present Value (NPV) method.


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August 2022

 2 Questions
Question 1b
​ ​ ​​
Dima Ltd. has developed a new product and is considering whether to put it into production. The following 
information is available: 

1.
Development costs will be Sh.4.8 million. 
2.
Production will require purchase of new machinery at a cost of Sh.2.4 million payable immediately. The machinery has a production life of four years and a production capacity of 30,000 units per annum.  
3.
Production costs per unit: Sh.
  • Variable material cost 8.00 
  • Variable labour cost 12.00 
  • Variable overheads 12.00
Fixed production costs including straight line depreciation on plant and machinery will amount to Sh.200,000 per annum.
4.
Selling price is Sh.80.00 per unit. Demand is projected at 25,000 units per annum. 
5.
The retail price index is expected to increase at a rate of 5% per annum over the period and selling price will increase at the same rate. Annual inflation rates on production costs are as follows: 

                                   (%) 
Variable material cost 4 
Variable labour cost  10 
Variable overheads    4 
Fixed costs                 5 
6.
The weighted average cost of capital (WACC) in nominal terms is 15%. 
  
Required: 
Advise the firm whether to undertake the production using the net present value (NPV) approach.


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Question 5a
​ ​ ​ ​​Hamsa Manufacturing Ltd. is considering two alternative investment proposals. The first proposal requires a major renovation of the company’s manufacturing facility. The second proposal involves replacing a few obsolete items of equipment in the manufacturing facility. The company is only able to select one of the two proposals. 

The cash flows associated with each proposal are shown below:

Year
Proposal I (Renovation) 
Proposal II (replacement of some items)

Sh.“000”
Sh.“000”
0
–9,000 
–1,000
1
3,500
600
2
3,000
500
3
3,000
400
4
2,800
300
5
2,500
200

The firm discounts cash flows at the rate of 15%. 

Required: 
(i) Rank the two investment proposals using the net present value (NPV) approach. 

(ii) Rank the two investment proposals using the internal rate of return (IRR) approach. 

(iii) Compare the rankings under the NPV and IRR approaches and comment on any differences. 


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April 2022

 1 Questions
Question 2c
​ ​ ​​Tuli Ltd. intends to invest in one of two machines; A or B. The following data is available:

Year
Machine A
Machine B
Cash inflows "Sh.000"
Cash inflows "Sh.000"
0
(30,000)
(30,000)
1
  8,400
8,400
2
  9,600
9,000
3
14,000
8,000
4
16,000
10,000  
5
  4,000
20,000  

Additional information: 
1. Both machines have a useful life of 5 years. 
2 Depreciation is on a straight line basis. 
3. The corporate tax rate is 30%. 

Required: 
Using pay back period as the criterion for project selection, advise the management of Tuli Ltd. on which machine to invest in.


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Pilot December 2021

 1 Questions
Question 1b
​ ​ ​​Mountain Mall (MM) Ltd. is considering a project with the following cash flows:

End year 
Cash flows
(Sh.)
0
-40,000
1
100,000
2
-20,000

Additional information: 
1. The firm’s cost of capital is 15%. 
2. Corporation tax rate is 30%. 

Required: 
(i) Compute the two internal rates of return (IRR) associated with these cash flows. 

(ii) If the firm’s cost of capital falls between the two IRR values calculated in b(i) above, advice the firm on whether to accept or reject the project. 


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December 2021

 1 Questions
Question 5a
​ ​ ​ ​​Bob Ltd. is contemplating replacing an existing machine which was purchased 5 years ago at a cost of Sh.825,000. The machine was expected to have a useful life of 10 years and an estimated salvage value of Sh.40,000 at the end of the 10th year. However, if replaced the existing machine can be sold in the market today at Sh.300,000.

The new machine will have an initial cost of Sh.1,200,000 and will have a useful life of 5 years. As a result of increased efficiency that will arise due to replacement of the existing machine, the firm will save Sh.168,000 per annum in production costs throughout the new machine's life. In addition, there will be annual savings in reduction
of wastages estimated at Sh.80,000.

The salvage value of the new machine is estimated at Sh.100,000 at the end of its useful life.

Additional information:
  1. The firm provides for depreciation on a straight-line basis.
  2. The cost of capital is 14%.
  3. The corporation tax rate applicable is 30%.
Required:
(i) Using the net present value (NPV) approach, advise the firm on the replacement decision.

(ii) State any two assumptions you made in your calculations in (a) (i) above.


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September 2021

 2 Questions
Question 5a
​Differentiate between the following terms as used in capital budgeting decisions: 

(i) "Hard capital" and "Soft capital"

(ii) "Sunk costs" and "Opportunity costs". 

(iii) "Independent projects" and "Mutually exclusive projects".


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Question 2b
​ ​ ​ ​ ​ ​ ​​Jahazi Limited is considering investing in the purchase of a machine for its manufacturing process at a cost of Sh.5,000,000. Installation cost of the machine is expected to be Sh.500,000. The machine is expected to have a useful life of five years, at the end of which, salvage value is estimated at Sh.800,000. This investment shall lead to increase in sales. In order to support increased sales, the firm requires an extra investment in working capital at the start of the machine's useful life. Inventory balances will increase by Sh.1,200,000, debtors balances will rise by Sh.1,500,000 and creditors balance will increase by Sh.1,700,000. The additional investment in working capital will be recovered at the end of the machine's useful life. 

The quantity of the product to be manufactured and sold in each year are estimated as follows:

Year
Quantity
(Units)
1
20,000
2
25,000
3
30,000
4
35,000
5
40,000

Additional information: 
1. The unit selling price and unit variable costs incurred are estimated at Sh.45 and Sh.15 respectively. These are expected to remain constant each year. 
2. The firm's estimated fixed operating costs excluding depreciation are Sh.100,000 per annum. 
3. The machine will require an overhaul at the end of the second year. This overhaul cost will amount to Sh.240,000. The overhaul cost will be ammortised separately on a straight line basis over the remaining useful life of the asset.
4. The firm provides for depreciation on a reducing balance basis at the rate of 32% per annum. 
5. The cost of capital is 13%. 
6. The corporation tax rate is 30%. 

Required: 
Using the net present value (NPV) technique, advise on the suitability or otherwise of the project. 


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May 2021

 2 Questions
Question 1b
​ ​ ​ ​​Nyakati Limited intends to invest in a four-year mini project whose initial outlay is Sh.32,000,000. The project is expected to generate the following cash flows at the end of each year:

Year
1
2
3
4
Cash flows (Sh. "000")
12,000
15,000
9,000
6,000

The cost of capital is 12%.

Ignore taxation. 

Required: 
Advise the management on whether to undertake the project using the internal rate of return (IRR) method.


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Question 1a
​​Explain four categories of capital investment projects.


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November 2020

 2 Questions
Question 5a
​ ​​Donese Bid has a capital structure that consists of Sh.150 million, 15% debentures and Sh.450 million in ordinary shares of Sh. 20 par value.

The company adopts a 100% payout ratio as its dividend policy.

The finance manager of Donnat Ltd. intends to raise an additional Sh.20 million to finance an expansion programme and is considering two alternative financing options:

Option 1: IIssue a 12% debenture stock.
Option 2: IIssue additional ordinary shares of Sh.20 par value.

The corporation tax rate is 30%

Required:
Calculate the earnings before interest and tax (EBIT) and earnings per share (EPS) at the point of indifference in firm's earnings under financing option (1) and (2) above,


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Question 4a
​ ​​Ulanda Engineering Works Ltd. is contemplating the purchase of a new machine to replace the existing one. The existing machine was purchased two years ago at an installed cost of Sh.500,000. The machine was estimated to have an economic life of 5 years with nil salvage value but a critical analysis of its performance now shows that it is usable for the next five years with a resale value of Sh.100,000. The current disposal value of existing machine is Sh 200,000

The new machine would cost Sh.600,000 and require Sh.50,000 in installation cost. Since the machine is not locally available, the company plans to import it and will pay import duty and freight charges of Sh. 150,000 and Sh.100,000 respectively The new machine shall require an overhaul at the end of third year which is expected to cost Sh. 100,000.

The overhaul cost is to be amortised on a straight line basis over the remaining useful life of the machine

To support the increased business resulting from purchase of the new machine, accounts receivable would increase by Sh.250,000, inventories and accounts payable shall increase by Sh.200,000 and Sh.300,000 respectively

At the end of five years, the new machine would be sold for Sh.250,000.

The estimated profit before depreciation and taxes over the next five years period for both machines are given as follow's.

Year
Existing machine
Sh."000"
New machine
Sh."000"
1
2
3
4
5
120
150
180
145
135
260
280
250
240
270

Additional Information:

  1. The corporation tax rate is 30%.
  2. The company uses the straight line method of depreciation,
  3. The cost of capital is 13%.
  4. Capital gains are tax exempt.

Required:
(i).  The incremental initial cash outlay.
(ii). The incremental net operating cash flows associated with the proposed machine replacement.
(iii). Should the existing machine be replaced? Justify your answer


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May 2019

 3 Questions
Question 4b
​ ​​Juhudi Industries intends to replace an existing machine with a new one which is more efficient. The existing machine was acquired 2 years ago at a cost of Sh.4 million. The useful life of this machine was originally expected to be 5 years with no salvage value. However, the valuer has now estimated that the machine shall have an economic useful life of 10 more years and a salvage value of Sh.500,000.

The new machine is estimated to cost Sh. 8 million. An additional installation cost of Sh.400,000 shall be incurred. The new machine has a useful economic life of 10 years. The financial analyst of the company estimates that the existing machine could be sold for Sh.2.5 million at the current prevailing market price.

The new machine is expected to increase sales whereby debtors would increase by Sh.320.000, inventory by Sh.140,000 while creditors would increase by Sh.300,000. 
The profit before depreciation and tax over the next 10 years for the two machines is given as follows: 

Year
New machine
Sh."000"
Existing machine
Sh."000"
1
2
3
4
5
6
7
8
9
10
350
400
420
410
410
380
380
350
300
280
280
300
320
340
340
320
310
280
260
240

Additional information: 
1.  The company's required cost of capital is 10%. 
2.  Corporate tax rate is at 30%. 
3.  The company uses a straight-line method of depreciation. 

Required: 
Using the net present value (NPV) method, advise the management of Juhudi Industries on whether to replace existing machine with the new one.


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Question 5c
​​(i) Explain the term "abandonment" as used in capital budgeting decisions.
(ii) Palakumi Agribusiness Ltd. is analysing a youth empowerment project. The following information is provided:

Year
Cash flow
(Sh. "million")
Abandonment value
(Sh. "million")
0
1
2
3
4
(16)
8
6
5
4
-
12
8
6
-
 
The company's cost of capital is 10%. 

Required: 
Advise the management of Palakumi Agribusiness Ltd. on the optimal time to abandon the project.


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Question 5d
​ ​​Bidii Enterprises is a small medium enterprise (SME) in floriculture industry. The company intends to invest Sh.300,000 in a project that has a useful economic life of 4 years.
 The following are the expected cash flows:

Year
1
2
3
4
Cash flows (Sh.)
140,000
120,000
80,000
60,000

The company's required rate of return is 14%.

Required: 
The modified internal rate of return (MIRR) of the project.


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November 2018

 3 Questions
Question 2a
​​Describe four limitations ot the net present value (NPV) method of investment appraisal.


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Question 2b
​​The management of Bundacho Limited is in the process of evaluating two projects, namely Alpha and Beta. 
The estimated pre-tax cash flows of each of the projects are as follows:

Year
Project Alpha
Pre-tax cash flows
Sh. "000"
Project Beta
Pre-tax cash flows
Sh. "000"
1
2
3
4
5
6
2,590
2,880
3,050
2,950
-
-
4,300
3,290
3,200
3,700
4,850
4,420

Additional information: 
1.    Project Alpha costs Sh.3.8 million and has an estimated lifespan of 4 years. 
2.    Project Beta costs Sh.8 million with an estimated lifespan of 6 years. 
3.    Both projects have a zero salvage value. 
4.    An investment in working capital of Sh.825,000 will be required irrespective of the project to be undertaken. 
5.    The cost of capital for the company is 12%. 
6.    The corporate tax rate is 30%. 

Required: 
Using the discounted payback period method, recommend to the management of Bundacho Limited on which project to undertake.


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Question 3a
​​Propose four factors that might lead to soft capital rationing in a limited company 


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May 2018

 3 Questions
Question 4c
​​(i) Describe two types of capital rationing in capital budgeting.
(ii) Amani Contractors Ltd. is intending to invest in four independent projects. The following information relates to the four projects:

Project
A
B
C
D
Present values of cash inflows (Sh. "million")
50
60
100
70
Initial outlay (Sh. "million")
(30)
(45)
(60)
(40)
Net present values (Sh. "million")
20
15
40
30
 
Additional information: 
1.   The company has a capital limitation of Sh.90 million. 
2.   The company's required rate of return is 10%. 
3.   Any surplus funds can be re-invested to generate a return of net cash flow of 14% in perpetuity. 
4.   The projects are indivisible. 
5.   The projects can be combined to achieve a higher return subject to the company's capital limitation. 

Required: 
Advise on the optimal project combination.


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Question 4d
​​Maua Ltd. is in the process of completing construction of a green house. 
The finance manager has estimated that the project's useful life is 15 years and shall generate the following cash flows:

Years
Cash flows (Sh. "000")
1 - 5
6 - 10
11 - 15
5,000
9,000
4,000
18,000

The required rate of return for the company is 10%. 

Required: 
The total present value of the project.


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Question 2b
​​Kubusa Ltd. is contemplating the acquisition of a new machine to replace the one currently being used in production process. The existing machine was acquired 2 years ago at a cost of Sh.8 million. The existing machine was estimated to have a useful life of 5 years with no salvage value. However, a critical analysis of the machine now shows that the machine is usable for the next 5 years with a salvage value of Sh.1.5 million. The existing machine can be disposed of now at Sh.4 million.

The new machine is expected to cost Sh.12.56 million with a salvage value of Sh.4 million at the end of its useful life of 5 years. The new machine will also require an additional investment in working capital of Sh.2.6 million at the start of its useful life which will however be recovered at the end of its useful life.

The following information relates to the estimated earnings before depreciation and tax (EBDT) over the coming five year period for the two machines: 

Year
New machine
(Sh. "000")
Existing machine
(Sh. "000")
1
2
3
4
5
5,400
5,400
5,400
5,400
5,400
3,200
2,800
3,000
2,400
2,000

Kubusa Ltd.'s cost of capital is 13%. The company applies straight-line method of depreciation. 

The corporate tax rate is 30%. 

Required: 
Using the net present value (NPV) technique, advise the management of Kubusa Ltd. on whether to replace the existing machine with the new machine. 
 


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November 2017

 1 Questions
Question 4c
​​Karem Bottling Company is considering replacing one of the bottling machines with a more efficient one.

The old machine has a current net book value of Sh.2,400,000 with a remaining useful life of five years. The old machine has an estimated re-sale value of Sh.200,000 at the end of its useful life.

The existing machine's current disposal value is estimated to be Sh.1,060,000.

The new machine has a purchase price of Sh.4,700,000 and an estimated useful life of 5 years. The machine is expected to have an estimated market value of Sh.600,000 at the end ofthe five years.

The machine is expected to economise on electric power usage and repair costs which will save the company Sh.920,000 each year. In addition, the new machine is expected to reduce the number of defective bottles which will save an additional amount of Sh.120,000 annually. 

The company's corporate tax rate is 30% with a required rate of return of 12%.

The company provides for depreciation on a straight line basis.

Assume capital gains are taxable.

Required: 
(i).      The initial net cash outlay. 
(ii).     The incremental net operating cash flows for years 1 through year 5. 
(iii).    The total terminal cash flows.
(iv).    Using net present value (NPV) criteria, advise the management of Karem Bottling Company whether or not to purchase the new machine.  


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May 2017

 1 Questions
Question 3b
​Roka Limited has two mutually exclusive projects namely, project A and project B with initial cash outlay of Sh.50,000 each. The projects have a useful life of 5 years. The company's cost of capital is 12% with a corporate tax rate of 30%

The expected cash flows for the projects before depreciation and tax are given below:

Year

1
2
3
4
5		Project A
"Sh.000"
42
42
42
42
42		Project B
"Sh.000"
62
32
22
52
52

The company uses straight line method of depreciation

Required:

Using the profitability index approach, advise the management of Roka Limited on the project to consider


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November 2016

 1 Questions
Question 4c
​​Mwarakaya Ltd. is considering the acquisition of a new machine to replace the existing machine currently being used in production processes. The existing machine was acquired 2 years ago at a cost of Sh.2,000,000. It was originally estimated to have a useful life of 5 years with no salvage value.

A critical evaluation of the machine now shows that the machine is usable for another 5 years with a salvage value of Sh.250,000 at the end of this period. The disposal value of the existing machine is currently estimated at Sh.1,250,000.

The new machine is estimated to cost Sh.3,140,000 and its estimated salvage value is Sh.1,000,000 at the end of its useful life of 5 years. The new machine will also require an additional investment in working capital of Sh.650,000 at the start of the asset's useful life.

The investment in working capital will however be recovered at the end of the 5 years useful life.

The following information relates to the estimated earnings before depreciation and tax (EBDT) over the coming five-vear period for the two machines. 

Year
New machine
Sh.
Existing machine
Sh.
1
2
3
4
5
1.400.000
1,350,000
3,000,000
1,450,000
1,200,000
800,000
700,000
750,000
650,000
600,000

The cost of capital is 10% and the firm applies the straight line method of depreciation. The corporate tax rate is 30%. 

Required: 
Using the net present value (NPV) technique, advise the company's management on whether to replace the existing machine. 
 


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May 2016

 3 Questions
Question 1b
​​ A firm is considering the following investment projects:

Project
Year 0
Year 1
Year 2
Year 3
A
1,000,000
500,000
500,000
-
B
1,000,000
-
650,000
   850,000
C
1,000,000
300,000
500,000
1,000,000
D
1,000,000
800,000
400,000
   400,000

The firm's opportunity cost of capital is 15%. 

Required: 
(i) Rank the projects using payback period method. 
(ii) Rank the projects using net present value (NPV) method.


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Question 4d
​Laika Ltd has identified five investment projects with the following details:

Investment
project
A
B
C
D
E		Initial outlay
(Sh. "millions")
120
160
100
90
110		Net present value of investment
(Sh. "millions")
24.0
43.2
17.0
21.6
19.8

Additional information:
1. None of the investment projects could be delayed.

2. Amount available for investment is limited to Sh.300 million. therefore, the company canno undertake the investment projects.

3. All the five projects are divisible.

Required:
Advise the management of Laika Ltd. on the most appropriate investment projects to undertake.


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Question 1a
Explain four principles of capital budgeting. ​​


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November 2015

 2 Questions
Question 3c
​​Nile group of hotels is considering the acquisition of Victoria hotel at a cost of Sh.200 million. The group of hotels cost of capital is currently 16% due to its high gearing level. Victoria hotel has no debt.

As a result of this acquisition, the cost of capital for Nile group of hotels will drop to 12%. Total cash flows will also increase by Sh.25 million per annum in perpetuity.

Required:
(i) Using the net present value (NPV) approach, advise the management of Nile group of hotels on the acquisition of Victoria hotel.

(ii) If the acquisition was funded by borrowing so that there is no impact on gearing after acquisition and the cost of capital was not reduced, advise the management of Nile group of hotels whether to proceed with the acquisition of Victoria hotel.


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Question 3b
The following details relate to a capital project in XYZ Limited:

Project cost
Annual cash flows (after tax)
Project economic life
Required rate of return		Sh.65,000,000
Sh.21,000,000
5 years
12%

Required:
Assess the suitability of the capital project using the following methods:

(i) Internal rate of return (IRR).

(ii) Profitability index (PI).


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Pilot September 2015

 2 Questions
Question 2b
​​ The management of Swara Ltd. is considering replacing an existing machine which was bought 3 years ago at a cost of Sh.20 million. The machine was expected to have a useful life of 5 years with no resale value at the end of this period. A critical evaluation of this asset shows that the existing machine is usable for another five years at the end of which resale value is estimated at Sh.2 million. The current disposal value of the existing machine is estimated at Sh.10 million.

The new machine is not locally available. The management expect to import this machine at a cost of Sh.40 million. Installation cost of this machine is estimated at Sh.500,000.

Import duty payable and freight charges are estimated at Sh.300,00 and Sh.200,000 respectively. This machine is expected to have a useful life of five years, at the end of which resale value is estimated at Sh.5 million.

This investment is expected to lead to increased sales. To support increase in sales, the firm will require an extra investment in working capital at the beginning of the new machine's useful life. Inventory balance is expected to increase by Sh.800,000, debtors balance will increase by Sh.700.000 and creditors balance will increase by Sh. 1,000,000.

However, the firm will require an extra investment in working capital at the end of the second year of Sh.250.000. The total investment in working capital will be recovered at the end of the machine's useful life.

The earnings before depreciation and tax to be generated by each asset during each year are given as follows:

Earning before depreciation and tax(EBDT)
Year

1
2
3
4
5		New machine
Sh."000"
70,000
75,000
85,000
80,000
70,000		Existing machine
Sh."000"
50,000
55,000
60,000
55,000
65,000

Additional information:
  1. The new machine shall require an overhaul at the end of third year. The overhaul cost is estimated at Sh.2 million. The cost will be amortised separately on a straight line basis.
  2. The firm provides for depreciation on all their non-current assets on a straight line basis.
  3. The firm pays corporation tax at the rate of 30%.
  4. The firm's capital structure which is optimal comprises of 70% equity and 30% debt. The cost of equity is 10% and before tax cost of debt is 8%.

Required:
Using the net present value technique, advise on whether the firm should replace the existing machine.


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Question 2c
​ ​​State two limitations of the net present value method.


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