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 $ 267,000 Labor costs 187,000 Other costs 57,000 The company will lease machinery for $92,000 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 12 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.) NPV $

Answer 1

Answer :

Calculation of NPV of Proposed Ranch :

As the discount rate is in real terms and cash flows are in nominal terms ,we need to convert nominal cash Flows into real cash Flows

Real Cash Flow = Nominal Cash Flow / (1 + rate of inflation )

Revenue Real Cash Flow = 267,000 / (1 + 0.06)

= $251,886.792452

Labor Real Cash Flow = 187,000 / (1 + 0.06)

= $176,415.094339

Other cost Real Cash Flow = 57,000 / (1 + 0.06)

= $53773.5849056

Lease payment Real Cash Flow = 92,000 / (1 + 0.06)

  = $86792.4528301

Net Present Value =[(Present Value of Revenue− Present Value of Labor costs− Present Value of Other costs− Present Value of Lease payments)] * (1 - Taxrate)

Present Value of Revenue = Revenue real Cash Flow / (Required rate of return - Growth rate)

= 251,886.792452 / (0.12 - 0.04)

= 3,148,584.90565

Present Value of Labour Cost = Labour Cost real Cash Flow / (Required rate of return - Growth rate)

= 176,415.094339 / (0.12 - 0.03)

= 1,960,167.71487

Present Value of Other Cost = Other Cost real Cash Flow / (Required rate of return - Growth rate)

= 53773.5849056 / (0.12 - 0.01)

= 488,850.771869

Present Value of Lease Payment = Lease Payment real Cash Flow / (Required rate of return - Growth rate)

= 86792.4528301 / [0.12 - (-0.06)]

= 482,180.2935

Note :Since lease payments are constant in nominal terms, so they are decliningby the rate of inflation.

Net Present Value =[(3,148,584.90565 − 1960167.71487− 488850.771869 − 482180.2935)] * (1 - 0.34)

= [217,386.12545 * 0.66]

= 143,474.842797 or 143,474.84