Question

 

Lolo Ltd have just made an investment of R400 000 in a machine.

Further details:

• Expected useful life                          5 years (straight line depreciation)

• Salvage value                                   120 000

• Cost of Capital                                  10 %

• Expected profit after tax data is as follows (tax rate is 30%):

Year                                                    Net Profit

1                                                          10 000

2                                                          40 000

3                                                          70 000

4                                                          125 000

5                                                          12 000

Required:

2.1      Calculate the Payback Period.                                                                                               (4)

2.2      Calculate the Accounting (Average) rate of return.                                                                (4)

2.3      Lolo Ltd requires a payback period of no more than 4 years and a return of at least

            30%. On the basis of these criteria, should this project be accepted?                              (4)

2.4       A financial advisor has informed the accountants of Lolo Ltd, that the above methods ignore the time value of money and has suggested they use the NPV method to assess project acceptance. Assist with the calculations and advise whether the project should be accepted?                                                                                                                         (8)

 

Lolo Ltd have just made an investment of R400 000 in a machine.

Further details:

• Expected useful life                          5 years (straight line depreciation)

• Salvage value                                   120 000

• Cost of Capital                                  10 %

• Expected profit after tax data is as follows (tax rate is 30%):

Year                                                    Net Profit

1                                                          10 000

2                                                          40 000

3                                                          70 000

4                                                          125 000

5                                                          12 000

Answer 1

Requirement-2.1:

*Depreciation = (R400,000 - 120,000)/5 years = R56,000

Payback Period = 3 + (112,000/181,000*12) = 3.7 years

Requirement-2.2:

Requirement-2.3:

Even if payback period is less than 4 years, ARR is less than 30%. Hence, the project should not be accepted.

Requirement-2.4:

Since, NPV is positive, the project may be accepted.