Question

In: Accounting

“Australia Cuts Interest Rates to Tame Coronavirus Pain; The cut makes the RBA the first developed-market...

Australia Cuts Interest Rates to Tame Coronavirus Pain; The cut makes the RBA the first developed-market central bank to cut rates in response to the coronavirus

WSJ Pro. Central Banking; New York (Mar 3, 2020).

SYDNEY—The Reserve Bank of Australia cut interest rates Tuesday in response to the growing threat from the coronavirus epidemic to the global economy, which threatens to snap the country's record run of 28 years without recession.

The RBA lowered its benchmark cash rate by 25 basis points to a new record low of 0.50%, with central bank Gov. Philip Lowe signalling further action was likely….”

You are the CFO of Pearson Pty Ltd which operates a courier service. You have conducted a capital budgeting analysis of purchasing a new van which is required to meet the increased demand for the company’s services. The choice has been narrowed down to two vans A and B, each costing $100,000. Net cash flow estimates are as follows:

Year

Van A

Van B

1

$51,000

$33,000

2

-$6,000

$41,000

3

$64,000

-$6,000

4

$56,000

$46,000

5

$42,000

6

$37,000

Before the outbreak of coronavirus, the analysis indicated that the required rate of return was 12 per cent for both vans. Following the RBA’s interest rate cuts, you believe that the 20 per cent of the required rate of return will not be appropriate to calculate the NPV.

Required:

(a) Select a new required rate of return based on current market condition and justify your decision.                                                      

(b) Calculate NPV of each van based on the new required rate of return you selected.                                                                            

(c) Advise which van should be purchased. Provide reasons and relevant calculations.

Solutions

Expert Solution

1- The required rate of return of this project which I choose is 15% because due to decline in interest rate WACC will decline from present level of WACC before interest rate cut but on the other hand uncertain economic conditions will put more pressure on the default part so default risk will increase and investors will demand more return on amount invested, this will increase the WACC.
2-
Year cash flow present value factor at 15% =1/(1+R)^n   r = 15% n =1,2,3,4 present value of cash flow =present value factor*cash flow
0 -100000 1 -100000
1 51000 0.869565217 44347.82609
2 -6000 0.756143667 -4536.862
3 64000 0.657516232 42081.03888
4 56000 0.571753246 32018.18175
net present value = sum of present value of cash flow 13910.18
Year cash flow present value factor at 15% =1/(1+R)^n   r = 15% n =1,2,3,4 present value of cash flow =present value factor*cash flow
0 -100000 1 -100000
1 33000 0.869565217 28695.65217
2 41000 0.756143667 31001.89036
3 -6000 0.657516232 -3945.09739
4 46000 0.571753246 26300.6493
5 42000 0.497176735 20881.42288
6 37000 0.432327596 15996.12105
net present value = sum of present value of cash flow 18930.64
3- Van B would be more beneficial to purchase as its NPV is greater than Van A at 15% discount rate

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