XYZ 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. Tax-allowable depreciation would be available on the cost of the machinery on a 25% reducing balance basis, with a balancing allowance or balancing 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: 

Selling Price: $650 per unit, forecast inflation 4.0% Variable cost: $250 per unit, forecast inflation 5.5% Incremental fixed costs: $250,000, forecast inflation 5.0% In addition to the initial cost of 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. XYZ 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: 

(a) Calculate the net present value of the planned purchase of the new machinery using a nominal approach and comment on its financial acceptability. 

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

Answer rating: 100% (QA)

a Calculation of NPV nominal approach Year 0 Investment in machinery 5000000 Investment in wo... View the full answer