Question

Tiger Ltd is contemplating a 3-year project that wil have sales that will grow 8 percent per year from a year 1 figure of $20 million (in nominal terms) and cash costs that will grow at 6 percent a year from a year figure of $4 million (in nominal terms). Machinery that needs to be purchased will cost $36 million and will last 3 years and is depreciated by the straight-line method to zero. This equipment will realise $8 million (pre-tax and in today's dollars) when resold at the end of the project. The annual inflation rate is expected to be 2 percent and the Tiger Ltd project has a WACC of 10 percent in real terms (as distinct from nominal); and the corporate tax rate and capital gains tax rate are both 30 percent. The NWC requirement each year for this project is 10 percent of sales. This investment is fully recovered at the end of the project Required: (a) What is the net present value of this project AND would you accept or reject it? Please show all workings (b) In answering Part (a) you will have either used either nominal cash flows or real cash flows. Required: Please find the NPV using the OTHER method (nominal cash flows or real cash flows). You will know if you have correct solutions to (a) and (b) as they will agree

Could you also brefly explain how to deal with the nwc part

Answer 1

Sales growth in real terms=8%-2%=6%

Cost growth in real terms=6%-2%=4%

Year	Revenue ($ mn)	Cost ($ mn)	Salvage Value ($ mn)	NWC ($ mn)	NWC recovery ($ mn)	Depreciation ($ mn)	Taxable Profit ($ mn)	Tax ($ mn)	Cash Flow ($ mn)	Discounted Cash Flow (Cash Flow/1.1^year)
0	(36)	-	-	-	-	-	-	-	(36)	(36)
1	20	(4)	-	(2)	-	(12)	2	1	13	12
2	21	(4)	-	(2)	-	(12)	3	1	14	12
3	22	(4)	8	(2)	6	(12)	18	5	25	19
									NPV (Total)	6

We have calculated NWC i.e. Net working capital as 10% of sales. Hence, for year 1 NWC=10%*20=$2 mn. Similarly, NWC for respective years has been calculated.

As the NPV is +$6.41 mn , so you should accept the project.

We have used real cash flow to calculate the NPV.