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Hey
NCW Co is considering investing $10,000 immediately in a one year project with the following cash flows.
Income $100,000
Expenses $35,000
The cash flows will arise at the end of the year. The above are stated in current terms. Income is subject to 10% inflation; expenses will not vary. The real cost of capital is 8% and general inflation is 2%. Using the money cost of capital to the nearest whole percentage, what is the net present value of the project?Answer:
(1 + money rate) = (1.08) × (1.02) = 1.1016 or m = 10%
Nominal income = $100,000 × (1 + income inflation) = $100,000 × 1.1 = $110,000
Nominal expenses = $35,000 (zero inflation)
Therefore NPV = [(110,000 – 35,000) × DF1] – 10,000
= (75,000 × 0.909) – 10,000 = $58,175My question is, where did the working capital go? It was supposed to be returned at the end of the project resulting in an inflow, right? Therefore in my opinion
NPV = [(110,000 – 35,000 + 10000) × DF1] – 10,000 x DF0
= (85,000 × 0.909) – 10,000 = $67,265What went wrong?
In future you must ask in the Ask the Tutor Forum if you want me to answer – this forum is for students to help each other.
You ask about working capital. However there is no mention of any working capital being needed in this example!!
The $10,000 is the cost of the investment and is nothing at all to do with working capital.
We would normally expect the investment to have a sale value at the end of the projects life (in which case there would be an inflow of whatever the sale value was), but if there is no mention of any sale value we assume it to be zero.
I do suggest that you watch my free lectures on investment appraisal. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.Oh yes. I totally misunderstood the question. Thanks for clearing that up.
BTW I do watch all your lectures. In fact, I passed 6 of my previous 8 papers using OpenTuition notes and lectures only (along with revision kit of course). The work that y’all are doing is a great help. Thanks a lot.
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