Question

Question 8

Olu ltd prepares its accounts to December 31 each year. It is considering investing in a new computer controlled production facility on January 1, 2016 at a cost of GHS50 million. This will enable Olu Ltd to produce a new product which it expects to be able to sell for four years. At the end of this time it been agreed to sell the new production facility for GHS1 million cash.

Sales of the product during the year ended December 31, 2016 and the next three years are expected to be as follows:

Year ended December 31         2016        2017        2018        2019

Sales in units (000)                     100          105           110          108

Selling price, unit variable cost and fixed overhead cost (excluding depreciation) are expected to be as follows during the year ended December 31, 2016.

                                                                                            GHS

Selling price per unit                                                         1,200

Variable production cost per unit                                      750

Variable selling and distribution cost per unit                 100

Fixed production cost for the year                          4,000,000

Fixed selling and distribution cost for the year     2,000,000

Fixed administration cost for the year                    1,000,000

The following rates of annual inflation are expected for each of the years during 2017-2019

                                                                               %

Selling prices                                                        5

Production costs                                                 8

Selling and distribution costs                            6

Administration costs                                           5

The company pays taxation on its profits at the rate of 30% with half of this being payable in the year in which the profit is earned and the remainder being payable in the following year.

Investments of this type qualify for tax depreciation at the rate of 25% per annum on a reducing balance basis. The Board of Director of Olu Ltd has agreed to use a 12% post-tax discount rate to evaluate the investment.

Required:

1. Advise Olu Ltd whether the investment is financially worthwhile.
2. Calculate the internal rate or return of the investment
3. Explain briefly how real rate or return and money rate or return would be applied in calculating the net present value of a project’s cash flow.

Answer 1

		2016	2017	2018	2019
Year	0	1	2	3	4
1.Sales units		100000	105000	110000	108000
2.Selling price /unit		1200	1260	1323	1389.15	Prev.*1.05 for inflation form 2017-2019
3.Sales $ (1*2)		120000000	132300000	145530000	150028200
4.Variable prodn.cost/unit		750	810	874.8	944.784	Prev.*1.08 for inflation form 2017-2019
5. Total Var. cost(1*4)		-75000000	-85050000	-96228000	-102036672
6.Variable sell.& distn. Cost/unit		100	106	112.36	119.1016	Prev.*1.06 for inflation form 2017-2019
7. Fixed prodn. Cost		-4000000	-4320000	-4665600	-5038848	Prev.*1.08 for inflation form 2017-2019
8.Fixed sell& distn.costs		-2000000	-2120000	-2247200	-2382032	Prev.*1.06 for inflation form 2017-2019
9.Fixed adm. Cost		-1000000	-1050000	-1102500	-1157625	Prev.*1.05 for inflation form 2017-2019
10. Depn.		-12500000	-9375000	-7031250	-5273437.5	as per wkgs.
11.EBIT(2+5+7+8+9+10)		25500000	30385000	34255450	34139586
12. Tax at 30%(11*30%)		-7650000	-9115500	-10276635	-10241876
13.1st 50% Tax cash outflow		-3825000	-4557750	-5138317.5	-5120937.8
14.2nd 50% tax Cash outflow			-3825000	-4557750	-5138317.5
15. NOPAT (11+13+14)		21675000	22002250	24559383	23880330
16. Add back:Depn.(Row 10)		12500000	9375000	7031250	5273437.5
17. Operating cash flows(15+16)		34175000	31377250	31590633	29153768
CAPEX cash flows
18.Intial cost	-50000000
19.ATCF on salvage					3223047	as per wkgs.
20.Total Annual FCFs(17+18+19)	-50000000	34175000	31377250	31590633	32376815
21. PV F at 12%(1/1.12^yr.n)	1	0.89286	0.79719	0.71178	0.63552
22. PV at 12%(20*21)	-50000000	30513392.86	25013752	22485588	20576051
23.NPV at 12%(sum of Row 22)	48588784
24. IRR (of FCF row 20)	53.73%

Year	25% onPrev. BV	Book value
0		50000000
1	12500000	37500000
2	9375000	28125000
3	7031250	21093750
4	5273438	15820313	Book vlaue at end yr.4
		1000000	Sale value
		14820313	Loss on sale
	Loss*30%/2	2223047	50% Tax CF saved on loss
		3223047	ATCF on salvage

a.YES. It is advisable & financially worthwhile as the NPV of the associated cash flows is POSITIVE   . & IRR 54% > the discount rate 12%

c. While calcualting NPV with real rate of return, we will not give effect to inflation & maintain the intial values given for year 0 , through -out the project. But increases other than inflation , will be taken into consideration.

All the final real cash flows will be discounted with the real discount rate & NPV found out as usual.

ie. 12% is rate under inflation

the real rate, r=

(1+Nominal Rate)=(1+Real rate)*(1+Inflation rate)

so, the real rate of discount will be

((1+Nominal rate)/(1+Inflation Rate))-1

We apply this formula, when we have a single inflation rate for all the inputs.