Question

Carla is considering a project where the Units will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs will rise with inflation. The project should last for 3 years. Straight line depreciation method would be used and there will be no salvage value. No change in net operating working capital would be required. What is the difference in the expected NPV before and after inflation? Equipment cost $250,000 Units sold 60,000 Price per unit $25.00 Fixed costs $150,000 Variable cost/unit $20 Depreciation rate 33.33% Expected inflation 4.00% Tax rate 40.0% WACC 10.0%

Answer 1

• The following table shows the cash flows of the project each year.

	Year 0	Year 1	Year 2	Year 3
1. Initial investment	-$250,000
2.Sales revenue		$1,500,000	$1,560,000	$1,622,400
3. Less: Variable cost @20		1,200,000	1,248,000	1,297,920
4. Less: Fixed costs other than dep		150,000	150,000	150,000
5. Less: Depreciation		66,660	66,660	66,660
6.Profit before tax		83,340	95,340	107,820
7.Less tax@40%		33336	38,136	43,128
8. Profit after tax		50,004	57,204	64,692
9.Add: Depreciation		66,660	66,660	66,660
10. Cash inflow after tax		116,664	123,864	131,352
11.Total cash flows (Row 1 + Row 10)	-$200,000	$116,664	$123,864	$131,352

• Sales price increases by 4% every year.Sales revenue would be

Year 1 = 60,000 * 25

Year 2 = 60,000 * 26

Year 3 = 60,000 * 27.04

• Variable costs also increase by 4% every year. Variable costs would be:

Year 1 = 60,000 * 20

Year 2 = 60,000 * 20.8

Year 3= 60,000 * 21.632

• Depreciation is taken as 33.33% of 200,000

Depreciation being a non cash expense, is added back to profit to arrive at cash flow.

• WACC is given as 10%. In order to find the present value of cash inflows,we multiply the cash inflows by present value interest factor (PVIF) at 10% for years 1, 2 and 3 respectively.
• Present value of cash inflows = (116,664 * 0.909) + (123,864 * 0.826 ) + (131,352 * 0.751) = $307,111.8257
• NPV = Present value of cash inflows - Initial investment

= 307,111.8257 - 200,000

= $107,111.83