Question

Pinks Co. is a large company listed on a major stock exchange. In recent years, the board of Pinks Co. has been criticised for weak corporate governance and two of the company’s non-executive directors have just resigned. A recent story in the financial media has criticised the performance of Pinks Co. and claims that the company is failing to satisfy the objectives of its key stakeholders. Pinks Co. is appraising an investment project which it hopes will boost its performance. The project will cost $20 million, payable in full at the start of the first year of operation. The project life is expected to be four years. Forecast sales volumes, selling price, variable cost and fixed costs are as follows:

Year	1	2	3	4
Sales (Units/ year)	300 000	410 000	525 000	220 000
Selling price ($/Unit)	125	130	140	120
Variable cost ($/Unit)	71	71	71	71
Fixed costs ($’000/year)	3000	3100	3200	3000

Selling price and cost information are in current price terms, before applying selling price inflation of 5% per year, variable cost inflation of 3.5% per year and fixed cost inflation of 6% per year. Pinks Co. pays corporation tax of 26%, with the tax liability being settled in the year in which it arises. The company can claim tax- allowable depreciation on the full initial investment of $20 million on a 25% reducing balance basis. The investment project is expected to have zero residual value at the end of four years.

Pinks Co has a nominal after-tax cost of capital of 12% and a real after-tax cost of capital of 8%. The general rate of inflation is expected to be 3.7% per year for the foreseeable future.

Required: Calculate:

1 The nominal net present values of Pinks Co’s investment project.

2 The real  net present values of Pinks Co’s investment project.

3 explain on the applicabiity of inflation rates on the real and nominal net present values

show all workings

Answer 1

(1) The Nominal NPV of Pink Co's Investment Project

Nominal Discounting Rate i.e. 12%, is used, Cash Flows also have been used in nominal terms without considering inflation.

NPV = Total Present Value Of Future Cash Flows After - Tax Initial Investment

NPV = 45,031 - 20,000 ($ in '000')

NPV = $ 25,031 ($ in '000')

(2) Calculation of NPV Considering Inflation.

Discounting rate used is 8%

Nominal Cash Flows have been coverted into the Real Cash Flows using respective inflation rates.

NPV = Total Present Value Of Future Cash Flows After - Tax Initial Investment

NPV = 49,018 - 20,000 ($ in '000')

NPV = 29,018 ($ in '000')

(3) Inflation has impacted sales price by 5% resulting in increase in Nominal estimates

Variable Costs have been inflated by 3.5% and Fixed Costs by 6%.

This has resulted in Overall Increase in Expected Cash Floes after Tax and thereby increase in the NPV also