Question

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Answer 1

Solution

Step 1: Inflation Treatment on each element based on the question.

The cost of capital in this question is real , which is 4.84%, the general inflation is 5 % therefore Nominal Cost of capital is =

[(1+ Real Interest Rate ) * ( 1+ General Interest Rate ) - 1]

= [(1+0.0484)* (1+0.05)-1] = [(1.0484*1.05) -1] = [1.10082-1] = 0.10082 or 10.08%

Inflation Table for each elements

Particulars	Rate of Inflation	Years
		1	2	3	4
Selling Price ( In $)	5%	370(1.05)= 388.5	370(1.05)2= 407.92	370(1.05)3= 428.32	370(1.05)4= 449.73
Variable Cost ( In $)	6%	280(1.06)= 296.8	280(1.06)2 = 314.61	280(1.06)3= 333.48	280(1.06)4= 353.49
Fixed Production Overhead ( In $)	7%	250,000(1.07)= 267,500	250,000(1.07)2= 286,225	250,000(1.07)3 = 306,260.75	250,000(1.07)4= 327,699

Step 2: Calculation of Cash Outflows

a) The expenditure on market study and shared development cost shall be ignored in the capital budgeting decision , since they are sunk cost and hence irrelevant in decision making, $50,000 and further $ 50,000 for the respective costs to be ignored.

b) Calculation of Relevant Cash outflows.

Sl No	Particulars	Amount ( In $)
a)	Initial Cash Outlay	2,025,000
b)	Present Value of Working Capital at Year 1 , is $400,000* PVF(1year, 10.08%)  (400,000* 0.9084)	363,372.09
c)	Release of Working Capital at Year end, is $400,000 * PVF (4year, 10.08%) ( $400,000* 0.6810)	272,400
d)	Net Cash outflow (a+b-c)	2,115,972.09

Step 3: Calculation of Cash Inflows

a) Tax shield on Depreciation

Years	Cost	Depreciation @ 25%	Closing Balance	Tax Rate	Tax Saving on Depreciation.
1	2,025,000.00	506,250.00	1,518,750.00	33%	167062.50
2	1,518,750.00	379,687.50	1,139,062.50	33%	125296.88
3	1,139,062.50	284,765.63	854,296.88	33%	93972.66
4	854,296.88	213,574.22	640,722.66	33%	70479.49

Calculation of Free Cash Flows

Years	1	2	3	4
Units (nos)	12,000	13,000	10,000	10,000
Selling Price ( In $ ) as computed in Step 1	388.5	407.92	428.32	449.73
Total sales ( In $) Units * Selling Price per Unit	4,662,000	5,302,960	4,283,200	4,497,300
Variable Cost per Unit ( In $ ) as computed in Step 1	296.8	314.61	333.48	353.49
Total Variable Cost ( In $) (Units * Variable Cost Per unit)	3,561,600	4,089,930	3,334,800	3,534,900
Contribution ( In $)	1,100,400	1,213,030	948,400	962,400
Fixed Cost (In $) as computed in Step 1	267,500	286,225	306,260.75	327,699
Additional Fixed Cost 10 % of (Variable Cost + Fixed Cost) ( In $)	382,910.00	437,615.50	364,106.08	386,259.90
EBT ( In $)	449,990.00	489,189.50	278,033.17	248,441.10
Tax @ 33 % ( In $)	148,496.70	161,432.54	91,750.95	81,985.56
EAT ( In $)	301,493.30	327,756.97	86,282.22	166,455.54
Add: Tax Saving on Depreciation (from a of Step 3) ( In $)	167,062.5	125,296.9	93,972.66	70,479.49
Free Cash Flows ( In $)	468,555.80	453,053.85	280,254.88	236,935.03
Discounting Factor @ 10.08 %	0.90840	0.8252	0.7496	0.6810
Discounted Value ( In $)	425,636.09	373,860.03	210,079.06	161,352.75

Total Discounted Value = $1,170,927.94

Loss on Sale of Assets =$ 25,000 - $640,722.66 = $615,722.66

Tax Saving on Loss on Sale of Assets = 615,722.66* 33% = $203,188.48

Net Cash Inflow at terminal period

a) Cash Inflow from Sale of Assets = $25,000

b) Tax Saving on Loss on Sale of Assets = $ 203,188.48

c) Net Present Value of Cash Inflow at Terminal Period (a+b)= $228,188.48 * 0.6810 = $155,396.35

Total Cash Inflow = $1,170,927.94 + $155,396.35 = $1,326,324.29

Step 4 : Net Present Values

Cash Inflow - Cash outflows = $1,326,324.29 - $2,115,972.09 = ($ 789,647.79)

Comment :

The Net Present Value is negative $789,648, considering the above inflation , therefore assets should not be purchased based on the above study.

B) Main assumptions which are implicit,

• The inflation rate expected to based on the above figures.
• The general inflation will effect the real rate of interest , and shall not expressly effect the sales , variable cost and fixed cost.

C) Strengths of Internal rate of return

• Determination of Indifference Point , as in IRR , Net Cash inflows = Net Cash outflows, therefore helps in assessing the Break even point of a Project, Machine Capacity etc.
• Analysis of Economic Viability of Project, or any Capital budgeting Decisions.
• Gives Importance to maximizing shareholder's wealth.
• It Provides a kind of cut off rate, where pre determined rate is not Possible as in case of NPV.
• Profitability is based on the entire economic life of a project or machine etc.

Weakness of Internal rate of return

• Ignoring the economies of scale.
• Difficult to determine the Internal rate for different projects , each have to be considered separately.
• Not helpful in mutually exclusive projects.
• Not reliable to give Rate of Return when there is a heavy flacuations in the cash flows, from negative to postive.