- 12 Marks
FM – L2 – Q78 – Discounted cash flow
Question
Woodland Enterprises plans to invest GH₵7 million in a new product. Net contribution over the next five years is expected to be GH₵4.2 million per annum in real terms. Marketing expenditure of GH₵1.4m per annum will also be needed. Expenditure of GH₵1.3m per annum will be required to replace existing assets which will now be used on the project but are getting to the end of their useful lives. This expenditure will be incurred at the beginning of each year. Additional investment in working capital equivalent to 10% of contribution will need to be in place at the start of each year. Working capital will be released at the end of the project. The following forecasts are made of the rates of inflation each year for the next five years:
| Contribution | Marketing | Assets | General prices |
|---|---|---|---|
| 8% | 3% | 4% | 4.70% |
The real cost of capital of the company is 6%. All cash flows are in real terms. Ignore tax.
Required:
Calculate the net present value of the project and appraise whether it is a worthwhile project.
Answer
| 0 | 1 | 2 | 3 | 4 | 5 | |
|---|---|---|---|---|---|---|
| Year | GH₵000 | GH₵000 | GH₵000 | GH₵000 | GH₵000 | GH₵000 |
| Contribution (inflation@8%) | 4,536 | 4,899 | 5,291 | 5,714 | 6,171 | |
| Marketing (inflation@3%) | ||||||
| Operating cash flows | ||||||
| New investment | (7,000) | |||||
| Asset replacement (inflation@4%) | (1,300) | (1,352) | (1,406) | (1,462) | (1,520) | |
| Working capital injection (W1) | (454) | (36) | (39) | (42) | (46) | 617 |
| Free cash flows | (8,754) | 1,706 | 1,969 | 2,257 | 2,572 | 5,165 |
| Discount factor @11% (W2) | 1 | 0.901 | 0.812 | 0.731 | 0.659 | 0.593 |
| Discounted cash flows | (8,754) | 1,537 | 1,599 | 1,650 | 1,695 | 3,063 |
| NPV | 790,000 |
The net present value = -8,754 + 1,537 + 1,599 + 1,650 + 1,695 + 3,063 = 790,000
The positive NPV shows the project is worthwhile.
WORKINGS
W1 Working capital injection
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|---|
| GH₵000 | GH₵000 | GH₵000 | GH₵000 | GH₵000 | GH₵000 | |
| Increased revenue | 4,536 | 4,899 | 5,291 | 5,714 | 6,171 | |
| Working capital required (10%) | ||||||
| Working capital injection | (454) | (36) | (39) | (42) | (46) | 617 |
W2 Cost of capital
(1+i) = (1+r)(1+h) = (1+0.06)(1+0.047) = 1.11, hence 11%
- Tags: Capital Investment, Contribution, Cost of Capital, Discounted cash flow, Inflation, NPV, Working Capital
- Level: Level 2
- Topic: Discounted cash flow
- Uploader: Samuel Duah