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.

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.