- This topic has 5 replies, 4 voices, and was last updated 6 years ago by
.
- Posts
Project E 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 acceptabilty. The project has a life of four years . Information relating to the future cash flows of this project are as follows:
Year 1 2 3 4
Sales volume(units) 12000 13000 10000 10000
Selling price($/unit) 450 475 500 570
Variable cost($/unit) 260 280 295 320
Fixed cost($’000) 750 750 750 750The forecasts are before taking into 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.
Required
Calculate the nominal after tax NPV of project E and comment on the financial acceptability of this project.My question is on how to calculate the nominal cost of capital that we use to discount these figures. In the solution, there was a sentence that said ‘As inflation rates differ for revenue and cost, nominal cash flows (including inflation)need to be calculated and discounted at the nominal rate (also including inflation)’. But there was no clear calculation as to how they arrived at the discount factor of 13%.
My second question is,although not directly related to this question, if prices are in current price terms does this mean that it does not include inflation and hence the reason for using a nominal rate to discount that includes inflation?
My third question is what is the difference between a nominal before-tax WACC and a nominal after tax WACC and when are they used?
Thank you for your help.
You really need to watch the free lecture on investment appraisal with inflation – I cannot type out the whole lecture here!!. Our lectures are a complete course covering everything you need to be able to pass F9 well!
There is no need to type out a whole exam question – this was in the June 2014 exam, and the last line of the question says “OAP has a nominal after-tax cost of capital of 13% per year”.
I assume that you are using the BPP Revision Kit. They copied part of the exam question, but forgot to type the last line!! (You can find the original question on the ACCA website)
The nominal cost of capital is the actual cost of capital, and we discount the nominal (actual) cash flows at the nominal (actual) cost of capital.
Since the cash flows are given at current prices, they do not include inflation and so they all need inflating to get the actual cash flows in order to then discount.We always use the after-tax cost of capital to discount investments. It is different than before tax because debt interest is allowable for tax. The before-tax cost of capital is rather meaningless. You need to watch the free lectures on the calculation of the cost of capital to understand.
DOES RESIDUAL VALUE HAVE IMPACT WHEN CALCULATING PAYBACK PERIOD,AND DISCOUNTED PAYBACK PERIOD
HOW DO WE TREAT SALVAGE VALUE IN INVESTMENT APPRAISAL
Please do not type in capital letters.
The residual value is not relevant for payback and discounted payback (certainly not in F9 anyway) because in exam questions it will always have paid back before the end of its life.
With regard to salvage value – it depends which method of investment appraisal you are asking about. I have already answered with regard to the payback method, but you are also expected to be aware of ROCE method and DCF method.
I do suggest that you watch the free lectures – I cannot obviously type them all out here 🙂
I am studying corporate finance. i need help for following question below.
Key Financial Data
Laid Back Sofas Ltd is intending to invest in machinery to meet the predicted levels of demand. Following various meetings with the senior management team and relevant members of staff the following financial data is available.
The cost of the machinery will be £8.2 million and is expected to last for four years. The residual value of the machinery at the end of the investment period will be £1.4 million (in money terms).
Alex Lloyd has liaised with his sales manager and they have predicted the following sales volumes for the new contracts: –
Year 1 2 3 4
Volumes (units) 7,200 9,100 6,300 4,200After undertaking significant market research the average selling price for the new business via the new high street stores will be £1,600 per unit and following production trials the average variable cost of production has been budgeted at £900 per unit. Annual incremental fixed production overheads are expected to be £350,000 per annum in real terms as a result of the decision to invest in the new machinery. Selling price, variable costs and fixed costs are in current terms.
Selling price, variable costs and fixed costs are expected to increase due to inflation as follows: –
Increase
Average selling price per unit 2.00% per annum Average variable cost of production per unit 3.00% per annum Fixed production overheads 4.00% per annum
The Business Analyst team have provided the following information in terms of a cost of capital: –
Real cost of capital 6.00% General Inflation 2.80%
Following discussions with her marketing director (Jessy Davies) Alex has agreed the following increased expenditure for the marketing budget (in money terms): –
Year 1 2 3 4
Expenditure £890,000 £1,200,000 £750,000 £680,000
Increased distribution costs associated with the project are as follows:
Year 1 2 3 4
% of sales revenue 5% 7% 6% 4%Investment in working capital associated with the project is (in money terms): – Year 1 2 3 4
Expenditure £380,000 £420,000 £360,000 £220,000Research and Development costs already incurred on the project have amounted to
£280,000.Laid Back Sofas Ltd pays corporation tax at the rate of 30% and there is a one year delay on paying tax. Capital allowances can be claimed at 25% on a reducing balance basis.
KPIs – Key Performance Indicators
As part of the internal financial decision making process the following KPIs have been agreed by the senior management team:
Payback Period Less than 3 years
Target ARR (Accounting Rate of Return) 20%
NPV Must meet general decision rules
IRR Must meet general decision rules
calculate NPV,ARR,IRR, payback
- The topic ‘Investment appraisal’ is closed to new replies.