14. The following information is available about an investment opportu- nity. In

Question

14. The following information is available about an investment opportu- nity. Investment will occur at time 0 and sales will commence at time 1. Initial cost Unit sales Selling price per unit, this year Variable cost per unit, this year Life expectancy Salvage value Depreciation Tax rate Nominal discount rate Real discount rate Inflation rate $28 million 400,000 $60.00 $42.00 8 years SO Straight-line 37% 10.0% 10.0% 0.0% a. Prepare a spreadsheet to estimate the project's annual ATCFs. b. Calculate the investment's internal rate of return and its NPV c. How do your answers to questions (a) and (b) change when you assume a uniform inflation rate of 8 percent a year over the next 10 years? (Use the following equation to calculate the nominal discount rate: in = (1 + i,)(1 + p)-1, where i, is the nominal discount rate, i, 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 NPV to decrease? e. Does inflation make this investment more attractive or less attractive? Why?

Explanation / Answer

Initial invetsmet 28000000 life 8yrs SP 60 6000% VC 42 units 400000 Dep SLM Tax rate 30% Nom rat 10% (b) 8% (a) After tax cashflows - 0 1 to 8 Initial investments -28000000 Sales (400000 x 60) 24000000 Less: Variable cost (400000 x 42) 16800000 Contribution 7200000 Less : Depreciation (28000000/8) 3500000 EBT 3700000 Less: Tax @ 30% 1110000 EAT 2590000 Add: Depreciation 3500000 ATCF -28000000 6090000 (b) NPV = PV of cash flows PV of annual cash flows = (6090000 x PVAF(10%,8) 32489700.55 Less; Initial investment 28000000 NPV = 4489700.545 IRR = When we discount cashflows using IRR NPV becomes 0 PV of cash inflow - Pv of cashoutflow = o 6090000 x PVAF(r,85) - 28000000 = 0 PVAF(r,8) = 28000000/6090000 = 4.597701 Using Linear interpolation = r PVAF(r,5) = 10% 5.3349 r 4.5977011 15% 4.4873 r-10/15-10 = (4.5977-5.3349)/(4.4873-5.3349) r-10= {-0.7372/-0.8476 } x 5 r = 4.3489+ 10 14.3489 (approx) (c ) New discount rate = (1.1)(1.08) -1 = 0.1880 18.8% New cashflows = After tax cashflows - 0 1 2 3 4 5 6 7 8 Initial investments -28000000 Sales (400000 x 60) 24000000 25920000 27993600 30233088 32651735.04 35263874 38084984 41131782 Less: Variable cost (400000 x 42) 16800000 18144000 19595520 21163162 22856214.53 24684712 26659489 28792248 Contribution 7200000 7776000 8398080 9069926.4 9795520.512 10579162 11425495 12339535 Less : Depreciation (28000000/8) 3500000 3500000 3500000 3500000 3500000 3500000 3500000 3500000 EBT 3700000 4276000 4898080 5569926.4 6295520.512 7079162 7925495 8839535 Less: Tax @ 30% 1110000 1282800 1469424 1670977.9 1888656.154 2123749 2377649 2651860 EAT 2590000 2993200 3428656 3898948.5 4406864.358 4955414 5547847 6187674 Add: Depreciation 3500000 3500000 3500000 3500000 3500000 3500000 3500000 3500000 ATCF -28000000 6090000 6493200 6928656 7398948.5 7906864.358 8455414 9047847 9687674 NPV - PV factors @ 18.8% 1 0.841750842 0.708544 0.596418 0.5020353 0.422588619 0.355714 0.299423 0.252039 Present value of cash flows = -28000000 5126262.626 4600721 4132375 3714533.2 3341350.891 3007712 2709132 2441676 NPV = 1073761.656 Calculation of IRR = NPV = 0 Discount factors @ r% 1 1/(1+r)^1 1/(1+r)^2 1/(1+r)^3 1/(1+r)^4 1/(1+r)^5 1/(1+r)^6 1/(1+r)^7 1/(1+r)^8 Using hit and trial (you may also use liner inter/extrapolation) or simply use excel IRR function) 19.9444% (d) Due to inflation the discount rate increases because of which pv factors decreases resulting in lower cashfllows; and hence resulting in lower NPV Whereas IRR is the rate at which NPV becomes 0 Due to inflation future value of cash flow increases that requires a higher rate to make NPV 0 (e) Inflation makes the project more attractive because it increases the chances of getting more in terms of sales and return to the potential investors. Please provide feedback…. Thanks in advance… :-)

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