CHAPTER 10 CAPITAL BUDG C4. (Excel: Inflation) Letter-Fly, Unlimited, a conglome
ID: 2786709 • Letter: C
Question
CHAPTER 10 CAPITAL BUDG C4. (Excel: Inflation) Letter-Fly, Unlimited, a conglomerate corporation with investments in overnight mail service and skeet-shooting franchises, is contemplating a five-year invest- ment project that requires an initial investment of $200,00 for equipment (depreciated over five years on a straight-line basis to a zero salvage value). The project also requires $25,000 in additional net working capital and is expected to have a salvage value of zero The revenues from the project are expected to be $100,000 in the first year and are expected to have an inflation rate of 3.5% per year over the life of the project. Expenses are expected to be $25,000 in the first year and are expected to have an inflation rate of6% per year. The general level of inflation for the economy is expected to be 5% per year. Ifthe required return on this project in real terms is 8% and taxes are paid at the rate of 32%, should Letter-Fly undertake the investment project?Explanation / Answer
0 1 2 3 4 5 Revenues in nominal terms (3.5% inflation) 100000 103500 107123 110872 114752 Expenses in nominal terms (6.0% inflation) 25000 26500 28090 29775 31562 Depreciation (200000/5) 40000 40000 40000 40000 40000 EBIT 35000 37000 39033 41096 43190 Tax at 32% 11200 11840 12490 13151 13821 NOPAT 23800 25160 26542 27946 29369 Add: Depreciation 40000 40000 40000 40000 40000 OCF 63800 65160 66542 67946 69369 Capital expenditure 200000 Net working capital 25000 Release of NWC adjusted for inflation at 6% -31562 [25000*1.06^4] FCF -225000 63800 65160 66542 67946 100931 PVIF at nominal required rate of return of 13.40% 1 0.88183 0.77763 0.68574 0.60471 0.53325 [See note below for working of nominal rate of return] PV at 13.40% -225000 56261 50670 45631 41087 53822 NPV 22472 Note:Nominal required rate of return = (1+real rate of return)*(1+inflation rate)-1 = 1.08*1.05-1 = 13.40% DECISION: As the NPV is positive, the investment can be undertaken.