Chapter 4
Chapter 4
cashflows
Chapter agenda
Use of real
interest rate in
Real Vs Nominal NPV
Interest rate Use of money
Impact of
interest rate in
Inflation Specific Vs NPV
General inflation
Accounting for rate
Chapter 4
working capital
Capital
Impact of tax
allowances
(1 + 𝑟)
(1 + 𝑖) =
(1 + ℎ)
You invest $10,000 in an account that pays 12% per annum. Inflation rate 5%. What is the
real return on the investment?
A project has the following cashflows before accounting for inflation. The company’s money
discount rate is 15%
Then similar to the example above, it is possible to calculate cashflows in money terms or
real terms
The company expects the following inflation rates per annum into the next 3 years
Evaluate the project, assuming that the machine has a life of five years and no scrap value.
When it comes to investment appraisal, tax charge on the company’s profits is a relevant
cash flow, hence it should be accounted for in the NPV analysis.
• Tax is typically paid one year after it is incurred (unless otherwise stated)
Tax-allowable depreciation (aka Writing Down Allowances WDA) is calculated on the written
down value of the asset either using straight-line method or the reducing balance method.
This is calculated as
A project that has a life of 4 years requires a company to purchase machinery for $100,000
now. At the of the project, the machinery is sold. Tax is payable at 20%, one year in arrears,
and tax-allowable depreciation is available at 25% reducing balance.
Required:
a) Calculate the tax depreciation and the resulting tax savings for each year if the
proceeds on disposal of the asset are $20,000.
b) How would your answer change if the asset were sold for $2,000?
c) Calculate the NPV of the project assuming that it generates a net cash flow of
$80,000 (before interest & tax) each year and cost of capital rate of 10%.
When undertaking a new project, in addition to the cost of the investment, funds are
required to invest in working capital.
A company is undertaking a 4-year project where net cashflows in year 1 are expected to be
$200,000. This is expected to grow at 10% per annum till the end of the project.
The company expects the working capital requirement to be 10% of the annual this needs to
be invested at the start of each year.
Calculate the working capital flows for incorporation into the NPV calculation.
• Make sure to inflate costs, revenues & disposal values by general/specific inflation
rates.
• Make sure to calculate working capital on the inflated values unless otherwise
stated.
Company ABC is considering a project which requires the purchase of machinery for $500
million today. ABC expects to dispose of the machinery at $100m at the end of the project.
It expects to sell 2.5, 5 and 3 million units in each of the next 3 years.
The selling price per unit is expected to be $120 and the variable cost is $40 per unit.
Tax rate is 30% which is paid one year after the accounting period in concern.
The working capital requirement is 15% of annual sales which must be invested at the start
of each year. Tax-allowable depreciation is 25% based on the reducing balance method.
The company has a real required rate of return of 7%. General inflation is predicted to be
3% per year but the selling price is expected to inflate at 4% and variable costs by 5% per
year.
Determine the NPV of the project. (All numbers must be rounded off to the nearest million)