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Hi John, just a quick question as i am a bit confused, if there is an npv cash flow question, for example an investment of 1,500,000, scrap at present value 2000,0000, we have the sales and variable cost projections as well as after tax cost of real cost of capital and after tax nominal cost of capital as well as the inflation rate of 4.7%,
1. how do we account for the values do we inflate them or not?
2. do we compute the tax savings if we opt for using the discount factor using fisher formula as we have an after tax cost of capital X % in this question it says after tax nominal rate of 11%, do we have to inflate the sales and variable costs as well as the working capital which is a % of sales
thanks much appreciated your support and help
Usually we calculate the nominal (actual) cash flows by inflating them, and discount at the actual WACC. If the real cost of capital is given then we use the fisher formula to calculate the nominal WACC.
Thanks John, what does after tax cost of capital mean, do we discount the tax savings on capital allowances and the profit after deducting the tax or we dont include the tax computations as the WACC is after tax
Hi John, I have been able to get the question that i am referring to would really appreciate it if you could elaborate on it and if you have the time perhaps you could do it?
Argnil Co is appraising the purchase of a new machine, costing $1·5 million, to replace an existing machine which
is becoming out of date and which has no resale value. The forecast levels of production and sales for the goods
produced by the new machine, which has a maximum capacity of 400,000 units per year, are as follows:
Year 1 2 3 4
Sales volume (units/year) 350,000 380,000 400,000 400,000The new machine will incur fixed annual maintenance costs of $145,000 per year. Variable costs are expected to be
$3·00 per unit and selling price is expected to be $5·65 per unit. These costs and selling price estimates are in
current price terms and do not take account of general inflation, which is forecast to be 4·7% per year.
It is expected that the new machine will need replacing in four years’ time due to advances in technology. The resale
value of the new machine is expected to be $200,000 at that time, in future value terms.
The purchase price of the new machine is payable at the start of the first year of the four-year life of the machine.
Working capital investment of $150,000 will already exist at the start of the four-year period, due to the operation of
the existing machine. This investment in working capital is expected to increase in nominal terms in line with the
general rate of inflation.
Argnil Co pays corporation tax one year in arrears at an annual rate of 27% and can claim 25% reducing balance
tax-allowable depreciation on the purchase price of the new machine. The company has a real after-tax weighted
average cost of capital of 6% and a nominal after-tax weighted average cost of capital of 11%.
Required:
(a) Using a nominal terms net present value approach, whether purchasing the new machine is financially acceptable.Because the question says to use a nominal approach, you need to calculate the actual cash flows by inflating them at the 4.7% per year, then calculate the tax in the normal way (on the actual cash flows) and then discount at the nominal cost of capital of 11%.
We always use the after-tax cost of capital, and all that ‘after tax’ means is that in calculating the WACC, the cost of debt has been calculating taking account of the tax saving on the interest.
Thank you, for the reply didnt inflate the values even though was inclining to do so
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