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Guys I have a problem that is playing a little tricks with me, on capital budgeting
When they say " All our projects are evaluated to take inflation and risk into account. For inflation, we adjust by using nominal cashflows(we adjust any real cashflows using the inflation rate)"
And then comoany wacc is 15%, risk free rate is 8%, inflation rate is 6%, and the market risk premium is 6%,excess funds can be re-invested at 12% and the company is established and has a beta of 0.9 which it also uses in evaluating core projects.
How do I go about it in terms of adjusting for inflation?
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Answers
Some general information was e-mailed to you by the bookkeeper:
The current machine has been written off but there is already a committed buyer who has agreed to pay R5000 for the old machine, which he wants to sell as scrap metal.
The company is taxed at 28%.
The machines are always depreciated on a straight- line basis over the usable life of the project.
Quotes from an installer have already been obtained. It will cost R2 000 000 to install either machine.
The company has always had such machines on their books and they need to be replaced at the end of their life. One can say that they are continually renewable projects.
The financial manager of the firm e-mailed you the following:
“All of our projects are evaluated to take inflation and risk into account. For inflation, we adjust by using nominal cash flows (we adjust any real cash flows using the inflation rate) and we adjust for risk by using a risk-adjusted discount rate (RADR) based on the coefficient of variation (CV) of the cash flows.
A risk adjustment is always made as follows:
If the CV is smaller than 0,5, the risk premium is multiplied by 0,8
If the CV is larger than 0,5 but smaller than 0,75, the risk premium is kept as is.
If the CV is more than 0,75, the risk premium is multiplied by 1,5.
Where the risk premium refers to WACC minus the risk free rate
The WACC of the company is 15%, the risk free rate is 8%, inflation is 6% and the market risk premium is 6%. Excess funds can be re-invested at 12%. The company is established and has a beta of 0,9 which it also uses in evaluating core projects.
When evaluating multiple projects, we compare net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR) and equivalent annual annuities (EAA) as well as the payback period. All of this information is passed on to decision makers so that they can start evaluating all projects that will at least offer acceptable returns.”
Cash flows of the respective machines have been estimated as follows:
Cash flows
Machine 1 (R000's) Purchase price 4000 Sales generated per year . 3500. Variable costs associated. 50% of sales Fixed costs associated 200
Increase in NOWC. 500
Economic lifespan 5 years Residual value @end of life 1500
Machine 2 (R000's)
Purchase price 5000 Sales generated per year 4500
Variable costs associated 40% of sales Fixed costs associated 500
Increase in NOWC 1000
Economic lifespan 4 years Residual value @end of life 2000
The sales generated per year were determined as follows:
Hint: The values above should be used in the determination of relevant cash flows,
the values below are for the CV calculation and not for the NPV calculation.
All values in R'000's.
Machine 1
Cash flow Probability 2000 0.1 3500 0.8
5000 0.1
Machine 2
Cashflow Probability
1000 0.2
4500 0.7
11500 0.1
Required:
Determine the:
1. Relevant cash flows (12)
2. Discount rates to be used (8)
3. NPV’s (2)
4. IRR’s (2)
5. MIRR’s (4)
6. Payback periods (2)
7. EAA’s; (4)
and making use of the given information, evaluate the acceptability of the two projects.
Also write a brief report regarding which one of the two machines would financially be better than the other, taking into account the information at hand only. Refer to your calculations findings in your report. (6)
Number your calculations as set out above and use the number to refer to your calculations in your report.
Its a long one
Answer said: for NPV, if you use nominal cashflows then you must discounted at nominal discount rates and if you use real cashflows, then you must discount in real discount rates. both should get the same answer.
so in this case, say for machine 1:
- you would need to adjust the sales, variable cost and fixed cost per year with 6% inflation. For example just for the sales figures:
- year 1 = 3,500 * (1.06)
- year 2 = 3,500 * (1.06)^2
- year 3 = 3,500 * (1.06)^3
- year 4 = 3,500 * (1.06)^4
- year 5 = 3,500 * (1.06)^5
does that help?