Dec 13 Q1 (Darn Co)

You will have to be more specific about what problem you are having with the answer. Usually we discount the nominal (actual) cash flows at the nominal (actual) cost of capital. This means inflating all of the flows to get the actual cash flows and then discounting at the 12% given to you in the question. The alternative (which we don't usually do, but is asked for here) is to discount the real cash flows (i.e. the cash flows without inflating them) at the real cost of capital (i.e. the cost of capital if there was no inflation, which you can calculate from the Fisher formula given on the formula sheet). I do suggest that you watch my free lectures on investment appraisal with inflation, where all of this is explained. (Our lectures are a complete course for Paper F9 and cover everything needed to be able to pass the exam well.)

Thanks. Can you please tell me how to calculate sales figure in this question

The sales in the first years are 1,250 before inflation. There will be one years inflation at 4.7% a year. Therefore the actual (nominal) cash flow is 1,250 x 1.047 = 1,308.75 The sales in the second year is 2,570 before inflation. There will be 2 years inflation at 4.7% per year. Therefore the actual (nominal) cash flow is 2,570 x (1.047)^2 = 2,817.26 Similarly for the other 2 years. Again, I really think you should watch the lectures on this. Calculating cash flows with inflation is very very commonly asked in the exam.

Thank you v much

you are welcome :-)

Could you please explain the working capital part in this question? The working capital has been recovered at the end of the fourth year. Is this due to the fact that the working capital has to be invested at the beginning of each year?

Working capital is always recovered at the end of the projects life (unless the question says otherwise) because it is no longer needed. I do suggest that you watch our free lectures on this, because it is explained in full. (Our lectures are a complete course for Paper F9 and cover everything needed to be able to pass the exam well.)

Right. But in June 2013 exam Q1(HDW), the working capital is not recovered at the end of the project life. I didn't notice anything specific mentioned in the question as to why it is not recovered

It is because the question said (in the second line) that at the end of its life the machine would be replaced. Therefore the product would continue to be manufactured and the working capital would still be needed. (The examiner accepted that this was unusual and said that students who had recovered the working capital would still get full marks.)

Thanks for your response John :) This was troubling me for quite a while.

Hi John, I don't fully understand the figure considere for the working capital of year 1. We need to deduct 130.88 (1st year working capital) from 281.73 ( 2nd year working capital ) and the same on happens on year two and three. Thanks in advance for the clarification! Regards,

You have obviously not watched my free lectures, because I actually work through an example explaining this in my lectures on relevant cash flows for investment appraisal!! The question tells you how much working capital is needed at the start of each year. If you already have working capital, then all we need is the extra to end up with the level that is needed. The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.