Question

The Biological Insect Control Corporation (BICC) has hired you as a consultant to evaluate the NPV of its proposed toad ranch. BICC plans to breed toads and sell them as ecologically desirable insect control mechanisms. They anticipate that the business will continue into perpetuity. Following the negligible start-up costs, BICC expects the following nominal cash flows at the end of the year: Revenues $ 273,000 Labor costs 193,000 Other costs 63,000 The company will lease machinery for $98,000 per year. The lease payments start at the end of Year 1 and are expressed in nominal terms. Revenues will increase by 4 percent per year in real terms. Labor costs will increase by 3 percent per year in real terms. Other costs will increase by 1 percent per year in real terms. The rate of inflation is expected to be 6 percent per year. The required rate of return is 11 percent in real terms. The company has a 34 percent tax rate. All cash flows occur at year-end.

What is the NPV of the proposed toad ranch today? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

On going through with the question, it is noted that all figures related to income and expenditures are at stated in nominal terms, where as discounting rate in Real Terms. We can calculate nominal income and all expenses by converting real terms into nomincal terms.

Step - 1 ……. Calculation of Nominal Discount rate
Real discount rates = 11% and inflation rate is 6%
Therfore, Nominal discount rate to be calculated as under :
= (1 + Real Discount Rate)(1 + Inflation Rate) – 1
= (1+0.11)(1+.06)-1
= 1.1766 - 1
= 0.1766 i.e. in terms of percentage = 17.66% or	0.1766
Step - 2 …….. Now we can convert real growth into nominal growth as under :
Parameters	% increase by	Growth	Inflation	Nominal	In percentage
	way of growth	a = (1+gr)	b = (1+ir)	(a x b)-1
Revenue	4% or 0.04	(1+0.04)=1.04	(1+0.06)=1.06	0.1024	10.24%
Labour	3% or 0.03	(1+0.03)=1.03	(1+0.06)=1.06	0.0918	9.18%
Other costs	1% or 0.01	(1+0.01)=1.01	(1+0.06)=1.06	0.0706	7.06%
Step - 3 …….. Calculation of present cash flow in nominal terms with perpetuity growth rate
The following formula to be used : Annuity value / (NDR - NGR) x (1+g)
Particulars	Amount	Nominal Discount	Nominal Growth	Growth Rate	Present Value
		rate (NDR)	Rate (NGR)	1 + g
	(a)	(b)	(c)	(d)	= a / [(b-c) x d]
Revenue	$2,73,000	0.1766	0.1024	1.04	$35,37,735.85
Labour	$1,93,000	0.1766	0.0918	1.03	-$22,09,653.78
Other Cost	$63,000	0.1766	0.0706	1.01	-$5,88,455.07
Lease Cost	$98,000	0.1766	-	-	-$5,54,926.39
				Total Present Value (pre- Tax)	$1,84,700.61
Less : Tax @ 34%					$62,798.21
				Present Value (Post Tax)	$1,21,902.40