The Insect Control Inc. (ICI) has hired you as a consultant to evaluate the NPV

ID: 2647066 • Letter: T

Question

The Insect Control Inc. (ICI) has hired you as a consultant to evaluate the NPV of its proposed toad ranch. ICI plans to breed toads and sell them as ecological desirable insect control mechanisms. They anticipate that the business will continue into perpetuity. Following the negligible start-up costs, ICI expects nominal cash flows at the end of the year as follows: Revenue GBP150,000 Labour costs GBP 80,000 Other costs GBP 40,000 The company will lease machinery for GBP20.000 per year. The lease payments start at the end of year 1. Revenue will increase by 5.00 percent per year in real terms. Labour costs will increase by 3.00 percent per year in real terms. Other costs will decrease by 1.00 percent per year in real terms. The rate of inflation is expected to be 6.00 percent per year. Id's required return is 10.00 percent in real terms. The company has 34.00 tax rate. All cash flows occur at year-end. What is the NPV of ICI's proposed toad ranch today?

Explanation / Answer

Use the approach similar to term in which growth data are given.

In this question the growth rate are given in real terms hence real term cash flow approach will be used.

Real cash flow approach

Step 1 : Translate all nominal cash flows into real cash flows by discounting at inflation rate.

Particulars

Working

Cash flows in $

Revenue

150000/1.06

141509

Labour cost

80000/1.06

75472

Other cost

40000/1.06

37736

Lease

20000/1.06

18868

Step 2 = use growing perpetuity formula to calculate present value in each case.

Cash flow in real terms (1