Bell Co has decentralised and divisional managers are allowed to make their own
investment decisions subject to confirmation by the main company board. Because each of
the three divisions (Ding, Dong and Merrily) are subject to different levels of risk, it has
been thought appropriate to use different discount rates in each division.
Ding has been told that its real discount rate is 5%. The general rate of inflation, based on
an index that uses a very wide range of prices, is 2%. In the industry in which Ding
operates, a number of prices are seen to be inflating at 3%.
Dong is assessing a project in which the first of four annual lease payments has been agreed
at $120,000. This is payable in one year’s time and subsequent payments will rise by
4% per annum. Ding’s proper money cost of capital is 8%.
Merrily is considering investing $1,000,000 in a project, which will produce the following
annual outflows and inflows.
Year 1 2 3
Outflows ($000) 1,800 2,500 1,500
Inflows ($000) 2,000 3,000 2,000
The cash flows, which arise at the end of each year, are stated in current year terms. It is
expected that outflows will rise by 3% per annum and inflows by 2% per annum. The
money cost of capital of the Merrily Division is 9%
ANSWER:
Time 0 1 2 3
$000 $000 $000 $000
Inflow (in money terms) – 2,040 3,121 2,122
Outflow (in money terms) (1,000) (1,854) (2,652) (1,639)
Net cash flow (1,000) 186 469 483
Present value at 9% (1,000) 171 395 373
NPV = $(61,000)
How did they get the inflows and outflows from time 2. When i am inflating it i am getting a different answer. Am i missing something?