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Hi,
Can someone please advise on the below?
Initial investment: £10 million
Selling price (current price terms): £50 per unit
Expected selling price inflation: 2% p/a
Variable operating costs (current price terms): £12 per unit
Incremental fixed costs (current price terms): £1 million p/a
Expected cost inflation: 3% p/aThe current CPI shows that the inflation in the economy is running at 6% p/a.
The R&D forecasts (which costed the company £550,000) that in:
Year 1 – 100,000 units
Year 2 – 300,000 units
Year 3 – 50,000 units
Year 4 – 180,000 unitsThe market will only last 4 years and that the equipment will have zero residual value at the end of the project.
Currently the company is 40% geared and the investors need an overall ‘real’ rate of return of 12% p/a. The company has a target rate of return on capital employed (based on average investment) of 35% p/a.
Calculate the NPV
thanks
You need to calculate the actual (nominal) cash flows by inflating at the rates given (3% and 2%) and then discount at the actual (nominal cost of capital which you can calculate using the fisher formula (with the real rate being 12% and the general inflation of 6%).
The free lecture on investment appraisal with inflation explains all this.
Dear John, thank you for your reply. I have followed the lectures which have assisted me in completing the NPV. Unfortunately I cannot post the answer here because it is in tabular format, but would appreciate if you take a look at my answer which can be found by accessing this link: https://www.dropbox.com/s/mtphrgdimeltdeh/OpenTution_Answer.xlsx?dl=0
Hopefully I got this right so I can feel confident in sitting for F9!
Thanks
Two pints:
Firstly, your first table discounts the current price flows at the real cost of capital. Although your arithmetic is correct, the approach is not valid because flows are inflating at different rates (which are also different from the general rate of inflation). Only ever do this if the question specifically asks you to. Otherwise you must use the second approach – i.e. inflate the flows and then discount at the money/nominal cost of capital.
Secondly, although you have calculated the cash flows correctly in your second table, you have not discounted them! They should be discounted at the nominal cost of capital which is (1.12 x 1.06) – 1 = 0.1872 or 18.72% (The examiner expects you to use tables to the nearest %, so discount at 19%).
Dear John,
Thank you for your input.
As you suggested, I revised my answer.https://www.dropbox.com/s/uqxi1jvi7b6brmo/OpenTution_Answer.xlsx?dl=0
Thanks
After working out the working provided in the above link (NPV including inflation), can I work out the payback period calculation as well? Or is it considered as an incorrect practice?
Thanks
You can certainly calculate the payback period – there are several measures that you might look at in practice.
However there is no point in the exam of calculating anything other than what is actually required.
(In future, if you have a question for me then please ask in the Ask the Tutor Forum – this forum is for students to help each other)
Hi John,
Thank you very much for all your help and assistance.
For further queries I will use the Tutor Forum.
Thanks again
I’m sorry if my question is put in inappropriate topic.
I am working on F9 pass exams and really confused about incremental working capital.
In exam Jun 2011, the answer for Question 1 from accaglobal.com shows that WC recovery is included in NPV calculation, but in some other exams (such as Q1 exam Jun 2013) incremental WC in the last year of operation is calculated as the other years of operation.Could someone help me to explain this, please?
In the final year, you always assume that you recover all of the working capital that has been paid out in the previous years.
(I do recommend that you watch the free lecture of this where the reasons for it are explained in full).In one question the examiner did not recover the working capital. The reason was that the question said that the machine would be replaced at the end of four years. Therefore presumably they would continue to manufacture the product, and therefore they would still need the working capital.
However, because this was very unusual, the examiner did say after that if the working capital had been recovered, then students would still get full marks (even though, obviously, the final NPV would be different)
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