This question required candidates to calculate the net present value (NPV) of an investment project in nominal terms and comment on its financial acceptability. Most candidates did well on this part of question 1.

Most candidates used a pro-forma NPV calculation, with operating cash flows at the start and other cash flows (tax and capital elements) later. This approach helps to avoid errors in the tax treatment of cash flows. However, some candidates wrongly classified incremental working capital as a tax-allowable deduction, resulting in tax calculation errors.

The question required a nominal terms approach and so sales revenue and costs needed to be inflated by the general inflation rate of 4.7% per year. Some candidates incorrectly multiplied each year’s figures by 1.047, rather than by 1.047 (year 1), 1.0472  (year 2), and so on. Some candidates did not know that nominal cash flows included the effects of inflation and used the uninflated cash flows provided in the question as nominal cash flows.

Most candidates correctly put the tax liability one year in arrears. Tax-allowable depreciation (capital allowances) was available on a 25% reducing balance basis and many candidates correctly calculated tax-allowable depreciation and its associated tax benefits.

Calculating the tax liability using the alternative approach of subtracting tax-allowable depreciation from net cash flow to give taxable profit, then adding back the tax- allowable depreciation as a non-cash item, received full credit. Some answers were not able to calculate the balancing allowance correctly.

A significant number of candidates were able to calculate correctly both initial and incremental working capital investment, which was based on sales income, and this topic was examined recently, which should have helped. However, errors in calculating working capital investment were the most common error found in candidates’ answers.

These errors included omitting the first year’s investment: calculating working capital investment on a  real terms basis while evaluating nominal terms cash flows; using total rather than incremental working capital investment; failing to reduce working capital investment when sales fell, but rather including the reduction in working capital (cash inflow) as an investment (cash outflow); failing to recover working capital at the end of the investment project, which was said to have an expected life of four years; putting total working capital as an initial investment, and incremental working capital investment as cash income in each year.

Most candidates correctly omitted the market research cost from their NPV calculation. This was a non-relevant cost as it would be incurred regardless of the outcome of the NPV calculation.

The nominal discount rate of 12% was correctly used by most candidates to discount their calculated nominal cash flows.

A comment on the financial acceptability of the investment project was required, and most candidates correctly referred to positive NPV as the reason for approval, sometimes relating this to increasing shareholder wealth. Some candidates lost marks by not referring to NPV or by not making any comment at all on financial acceptability.