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Hi sir,
I had an issue regarding the calculation of the real NPV in this question. They gave two approaches to calculate real NPV: one being using cash flows without taking into account the general inflation and the other being deflating the nominal cash flows from part (a) at the general rate of inflation to give real cash flows. My problem is with the second approach; after deflating the nominal cash flows and discounting them at the real discount rate, they have deducted the initial investment and the nominal working capital investment at year 0 (130880 – calculated as 10% of the nominal sales revenue in y1) from the PV of real cash flows. Why didn’t they use the real WC investment at year 0 (125000 – calculated from the real sales revenue in y1)? Is there a reason for this?Also, could you please clarify if we should use nominal after tax cash flows or before tax cash flows to calculate the real cash flows if they question asks us to or if both approaches are acceptable?
I am not able to look at the question until tomorrow. So I will answer you then.
The actual sales revenue in the first year is 1250 x 1.047 = 1308.75
Therefore the working capital needed at the start of the first year is 130.88.
The first year starts now (time 0) and so there is an outflow at time 1 of 130.88.Working capital is the amount needed to finance receivables etc., if the sales increase then the working capital required will increase also.
The reason for deducting the nominal working capital investment at year 0 (130880) instead of the real working capital investment at year 0 (125000) is because the calculation of the real cash flows involves deflating the nominal cash flows by removing the general rate of inflation.
The general rate of inflation affects all cash flows uniformly, including the working capital investment. Therefore, when deflating the nominal cash flows to obtain the real cash flows, the working capital investment is also deflated by the same rate. As a result, the nominal working capital investment is deducted from the present value of the real cash flow
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