ACCA FM Syllabus D. Investment Appraisal - Money & Real Rates - Past Papers ^{2 / 4}

Darn Co has undertaken market research at a cost of $200,000 in order to forecast the future cash flows of an investment project with an expected life of four years, as follows:

These forecast cash flows are before taking account of general inflation of 4•7% per year. The capital cost of the investment project, payable at the start of the first year, will be $2,000,000. The investment project will have zero scrap value at the end of the fourth year. The level of working capital investment at the start of each year is expected to be 10% of the sales revenue in that year.

Capital allowances would be available on the capital cost of the investment project on a 25% reducing balance basis. Darn Co pays tax on profits at an annual rate of 30% per year, with tax being paid one year in arrears. Darn Co has a nominal (money terms) after-tax cost of capital of 12% per year.

Required:

Calculate the net present value of the investment project in real terms and comment on its financial acceptability. (7 marks)

HDW Co is a listed company which plans to meet increased demand for its products by 
buying new machinery costing $5 million. The machinery would last for four years, at the end of which it would be replaced. The scrap value of the machinery is expected to be 5% of the initial cost. Capital allowances would be available on the cost of the machinery on a 25% reducing balance basis, with a balancing allowance or charge claimed in the final year of operation.

This investment will increase production capacity by 9,000 units per year and all of these units are expected to be sold as they are produced. Relevant financial information in current price terms is as follows:

In addition to the initial cost of the new machinery, initial investment in working capital 
of $500,000 will be required. Investment in working capital will be subject to the general rate of inflation, which is expected to be 4·7% per year.

HDW Co pays tax on profits at the rate of 20% per year, one year in arrears. The company has a nominal (money terms) after-tax cost of capital of 12% per year.

Required:

Discuss the difference between a nominal (money terms) approach and a real terms approach to calculating net present value.

(5 marks)