when we do project appraisal through Money term approach, we inflate the cash flow according to the relevant inflation rate & use Monetary wacc to discount those cash flow…
but there could be another scenario that our annual cash flows are fixed (eg. paying annual insurance premiums) meaning that these cash flows would’nt inflate as inflation rises irrespective of the inflation rate in the country, so in this kind of scenario whether we are to use Monetary Wacc or Real Wacc for discounting?
let me give an example of such case: assume that we are to pay fixed 50,000 annual premium for 20 years and at the end of 20th year we will get 4Million inflow (like happens in Insurance policy), we assume that inflation rate in country would be 10% YoY and we require just 2% Real Return; How should we do its appraisal? What would be the discount rate i.e money rate or real rate?

Sir one more question
Why havent we used after tax cost of capital here
What i mean is here we have tax deductions like in the next example
So why havent we used after tax cost of capital here ?

As you said sir
That because of tax payment in 1 year arrears we calculated 4th year cash flows and therefore when calculating npv we added 4th year PV
Firstly I wanted to clarify that if the tax payment was 2 year in arrears then the years would have gone to 5 ?
Secondly if there was no tax payment and allowances we would have stayed at year 3 only right ?

Thank you for this lecture. Indeed example 5 is a full standard section C question. So far you have been using reducing balance method for capital allowances but what if the question say capital allowances 25% straight line. What’s then is the approach.

Well then you use the straight line method as in Paper FA – i.e. an equal amount each year. Strictly the amount should be the initial cost spread over the life of the project, but the examiner does also allow you to take the cost less the scrap value spread over the life of the asset.

Good Morning I understood the lecture but i have a tricky question i want resolved. can you explain what is required of me in the question posted below.
The directors of M &R plc wish to expand the company’s operations. However, they are not prepared to borrow at the present time to finance capital investment. The directors have therefore decided to use the company’s cash resources for the
expansion programme.
Three possible investment opportunities have been identified. Only £600,000 is available in cash and the directors intend to limit the capital expenditure over the next 12 months to this amount. The projects are not divisible and none of them can be postponed. The following cash flows do not allow for inflation, which is expected
to be 12% per annum constant for the foreseeable future.
Expected net cash flows (including residual values)
Initial investment Year 1 Year 2 Year 3
Project £ £ £ £
A -310,000 96,000 113,000 210,000
B -115,000 45,000 42,000 47,000
C -36,000 -41,000 -23,000 127,000

The company’s shareholders currently require a return of 16 per cent nominal on their investment. Ignore taxation.

Required

a) Explain how inflation affects the rate of return required on an investment project, and the distinction between a real and a nominal approach to the evaluation of an investment project under inflation.
b)
I. Calculate the expected net present value and profitability indexes of the three projects; and
II. Comment on which project(s) should be chosen for the investment, assuming the company can invest surplus cash in the money market at 10 per cent.
c) Discuss whether the company’s decision not to borrow, thereby limiting investment expenditure, is in the best interests of its shareholders.

Please do not type out full questions like this as a comment on a lecture. You should ask questions in the Ask the Tutor Forum (although do not expect to be provided with a full answer – you will obviously have an answer in the same book in which. you found the question so ask about whatever it is in the answer that you are not clear about.

This is a question on capital rationing and so I suggest that you watch the lecture on capital rationing.

Hi John, I am little bit confused about which year to start applying the inflation rates on the selling price and variable cost.

1st Scenario: The current selling price is $30 per unit and is expected to increase by 5% a year. The suggested answer started applying the inflation in year 2.

2nd Scenario: The selling price of product SEP (in current price terms) will be GH¢20 per unit and inflation is expected to be 4% per year. The suggested answer started applying the inflation in year 1.

Please can someone help me on why the different treatment.
Thank you.

It depends on the precise wording in the question. If a flow is given at ‘current prices’ then it automatically inflated in the first year. If, on the other hand, you are told what the initial selling price will be in the first year then it doesn’t inflate until the second year.

Hello Sir,
For year 3, I’m having a little confusi9n about the total of 1694. Can you ex0lain me how did we got this number?
And why did we add 200 in year 3.

Thank you for the lectures, I enjoy them very much. I have a question regarding the tax allowance in the question. The tax allowance is higher than the actual tax payable, which generates additional cash inflow. Shouldn’t the maximum tax allowance be the actual tax payable?

No. It is because we always assume that the company is already making profits and is therefore already paying tax. Doing an extra project means they pay more tax because of the extra profits, but save tax on the extra capital allowances.

SMAbbas says

Dear Sir John Moffat,

when we do project appraisal through Money term approach, we inflate the cash flow according to the relevant inflation rate & use Monetary wacc to discount those cash flow…

but there could be another scenario that our annual cash flows are fixed (eg. paying annual insurance premiums) meaning that these cash flows would’nt inflate as inflation rises irrespective of the inflation rate in the country, so in this kind of scenario whether we are to use Monetary Wacc or Real Wacc for discounting?

let me give an example of such case: assume that we are to pay fixed 50,000 annual premium for 20 years and at the end of 20th year we will get 4Million inflow (like happens in Insurance policy), we assume that inflation rate in country would be 10% YoY and we require just 2% Real Return; How should we do its appraisal? What would be the discount rate i.e money rate or real rate?

John Moffat says

You must ask this sort of question in the Ask the Tutor Forum and not as a comment on a lecture.

SMAbbas says

Sir i had asked there as well but haven’t got the reply yet..!

AliSher123 says

Sir one more question

Why havent we used after tax cost of capital here

What i mean is here we have tax deductions like in the next example

So why havent we used after tax cost of capital here ?

John Moffat says

The cost of capital is always after tax, and so 10% is already after tax. (See later my lectures on the calculation of the cost of capital).

AliSher123 says

As you said sir

That because of tax payment in 1 year arrears we calculated 4th year cash flows and therefore when calculating npv we added 4th year PV

Firstly I wanted to clarify that if the tax payment was 2 year in arrears then the years would have gone to 5 ?

Secondly if there was no tax payment and allowances we would have stayed at year 3 only right ?

John Moffat says

What you have written is correct.

samrap23 says

helo Sir, Pleas why didnt you include the Fixed Overhead in the calculations

John Moffat says

Unless told otherwise we always assume that the total fixed overheads are not changing. So there is no extra cost.

asher2019 says

Thank you for this lecture. Indeed example 5 is a full standard section C question. So far you have been using reducing balance method for capital allowances but what if the question say capital allowances 25% straight line. What’s then is the approach.

John Moffat says

Well then you use the straight line method as in Paper FA – i.e. an equal amount each year. Strictly the amount should be the initial cost spread over the life of the project, but the examiner does also allow you to take the cost less the scrap value spread over the life of the asset.

Chimymy says

Good Morning I understood the lecture but i have a tricky question i want resolved. can you explain what is required of me in the question posted below.

The directors of M &R plc wish to expand the company’s operations. However, they are not prepared to borrow at the present time to finance capital investment. The directors have therefore decided to use the company’s cash resources for the

expansion programme.

Three possible investment opportunities have been identified. Only £600,000 is available in cash and the directors intend to limit the capital expenditure over the next 12 months to this amount. The projects are not divisible and none of them can be postponed. The following cash flows do not allow for inflation, which is expected

to be 12% per annum constant for the foreseeable future.

Expected net cash flows (including residual values)

Initial investment Year 1 Year 2 Year 3

Project £ £ £ £

A -310,000 96,000 113,000 210,000

B -115,000 45,000 42,000 47,000

C -36,000 -41,000 -23,000 127,000

The company’s shareholders currently require a return of 16 per cent nominal on their investment. Ignore taxation.

Required

a) Explain how inflation affects the rate of return required on an investment project, and the distinction between a real and a nominal approach to the evaluation of an investment project under inflation.

b)

I. Calculate the expected net present value and profitability indexes of the three projects; and

II. Comment on which project(s) should be chosen for the investment, assuming the company can invest surplus cash in the money market at 10 per cent.

c) Discuss whether the company’s decision not to borrow, thereby limiting investment expenditure, is in the best interests of its shareholders.

John Moffat says

Please do not type out full questions like this as a comment on a lecture. You should ask questions in the Ask the Tutor Forum (although do not expect to be provided with a full answer – you will obviously have an answer in the same book in which. you found the question so ask about whatever it is in the answer that you are not clear about.

This is a question on capital rationing and so I suggest that you watch the lecture on capital rationing.

JeffOsei says

Hi John, I am little bit confused about which year to start applying the inflation rates on the selling price and variable cost.

1st Scenario: The current selling price is $30 per unit and is expected to increase by 5% a year. The suggested answer started applying the inflation in year 2.

2nd Scenario: The selling price of product SEP (in current price terms) will be GH¢20 per unit and inflation is expected to be 4% per year. The suggested answer started applying the inflation in year 1.

Please can someone help me on why the different treatment.

Thank you.

John Moffat says

I do explain this point in my lectures.

It depends on the precise wording in the question. If a flow is given at ‘current prices’ then it automatically inflated in the first year. If, on the other hand, you are told what the initial selling price will be in the first year then it doesn’t inflate until the second year.

JeffOsei says

Thank you Sir. I get it

John Moffat says

That’s great 🙂

gree says

Can someone please explain me why cost scrap is considered as 2800 and not 1000?

gree says

Sorry for the question.

I got it

Cost is (2800) and scrap is 1000 in year 0 and year 3 respectively.

John Moffat says

Correct 🙂

priyankar5 says

Hello Sir,

For year 3, I’m having a little confusi9n about the total of 1694. Can you ex0lain me how did we got this number?

And why did we add 200 in year 3.

Thank you

John Moffat says

1694 is the total of the cash inflows less the cash outflows.

200 is added as the recovery of the working capital as explained in the earlier lecture on working capital.

John Moffat says

Because (as I explain in the lecture) there are no extra fixed overheads to the company – it i s simply a reapportionment of existing fixed overheads.

sheen00 says

Why didnt you minus the fixed overhead and then calculate the tax of 25%??

polyteknica says

Dear sir,

Thank you for the lectures, I enjoy them very much. I have a question regarding the tax allowance in the question. The tax allowance is higher than the actual tax payable, which generates additional cash inflow. Shouldn’t the maximum tax allowance be the actual tax payable?

Kind regards,

Gabriel

John Moffat says

No. It is because we always assume that the company is already making profits and is therefore already paying tax. Doing an extra project means they pay more tax because of the extra profits, but save tax on the extra capital allowances.

polyteknica says

Thank you for the clarification, my mistake as I didn’t put the whole picture of the company.