The following information is available about an investment opportunity. Investme

ID: 1171002 • Letter: T

Question

The following information is available about an investment opportunity. Investment will occur at time 0 and sales will commence at time 1.

a. prepare a spreadsheet to estimate the project's annual after-tax cash flows

b. calculate the investment's internal rate of return and its NPV

c. how do your anwsers to a & b change when you assume a uniform inflation rate of 8% a year over the next 10 years? (use the following equation to calculate the nominal discount rate in = (1 + ir)(1 + p) - 1, in is the nominal discount rate, ir is the real discount rate, and p is expected inflation)

d. how do you explain the fact that inflation causes the internal rate of return to increase and the net present value to decrease?

Initial cost $28 million Unit sales 400,000 Selling price per unit, this year $60.00 Variable cost per unit, this year $42.00 Life expectancy 8 years Salvage value $0 Depreciation Straight-line Tax rate 37% Nominal discount rate 10.0% Real discount rate 10.0% Inflation rate 0.0%

Explanation / Answer

a.Project’s Annual After Tax Cash Flows

Year

1-8

Inital Outflow

(28)

Sales 400,000*60

Less: Variable Cost

(16.8)

Less: Depreciation 28/8

(3.5)

Profit Before Tax

3.7

Less: Tax @37%

1.369

Profit After Tax

2.331

Add: Dep

3.5

Annual Cash Flows After Tax

5.831

b. Investment’s IRR is the rate at which NPV = 0

i.e. Present Value pf Cash Inflows – Present Value of Cash Outflows = 0

i.e. 5.831*PVAF(r%,8yrs) – 28 = 0

Which means PVAF(r%, 8yrs) = 4.8019

By looking into PVAF table, we see that IRR lies between 12% and 13%

NPV at 12% = 5.831*4.968 – 28 = 0.968408

NPV at 13% = 5.831*4.80 – 28 = -0.112

Therefore, using interpolation technique,

IRR = 12% + 0.968408/1.080408 = 12.90% (approx)

NPV = Present value of Cash Inflows – Present Value of Cash Outflows

= 5.831*5.335-28 = 3.108385 million

c. Nominal Discount Rate = (1+ 10)(1+0.8)-1

=18.8%

Part a – Annual Cash Flows will remain the same

Part b - IRR will remain the same

NPV will decrease due to higher discount rate

Revised NPV = 5.831*3.979 - 25 = -4.798451 million