write down a memo using te data provided ?

Case 37

Browns Nursery (Part B)

Jo Brown realizes that her initial analysis of the nursery addition in Browns Nursery (Part A)

ignored inflation. She has asked you to reevaluate the project with the following

modifications:

1. General inflation for the next five years is expected to average 3% per year.

2. Her contract is fixedi.e., the income from sales is in actual (or Yeart) dollars.

3. The land is expected to appreciate 5% per year.

4. The salvage value is stated in constant-value (Year0) dollars.

5. The working capital needs will pace inflation.

6. Variable costs will pace inflation (as will the annual savings).

7. Overhead costs will inflate 1% less than inflation.

8. Jos MARR is a market rate.

When there is inflation given in the problem, we need to first identify which cash flows are real cash flows and which are nominal cash flows.

Real cash flows are those which do not get effected due to inflation.They have to be discounted at real rate.

Nominal cash flows are those which are effected due to inflation.They have to be discounted at nominal rate.

1+Nominal rate = (1+Real rate) * (1+Inflation rate)

1.Nominal rate for variable costs other than overheads:

Real rate = 12%

Inflation rate = 3%

Therefore using above formula Nominal rate =15.36%

2.Nominal rate for overheads:

Real rate = 12%

Inflation rate for overheads = 2%

Therefore using above formula Nominal rate = 14.24%

Year	1	2	3	4	5
Variable costs	250000	245000	240000	235000	230000
Present value Discounting factor @ Nominal rate 15.36%	0.8669	0.7514	0.6514	0.5646	0.4895
Present value i.e discounted variable costs	216725	184093	156336	132681	112585
Overhead costs	30000	30000	30000	30000	30000
Present value discounting factor @ Nominal rate 14.24%	0.8754	0.7662	0.6707	0.5871	0.5139
Present value i.e discounted variable costs	26262	22986	20121	17613	15417

From the above table it can be concluded that:

Cumulative present value of Variable costs = 802420

Cumulative present value of Overgeads = 102453

Discounted Sales per year for 5 years

=380000 x Present value annuity factor for 5 years @ 12%

=380000 x 3.6048

i,e 13,69,824

Present value of salvage values of green house spaces and land:

Land = 200000 x 0.5674 = 113480

Greenhouse spaces = 40000 x 2 x 0.5674 = 45,392

Total present value of salvage values = 158872

Now we need to compare the present values of various cash inflows and outflows to take a decion :

Present value of Cash outflow:

Particulars	Amount
Land	200000
Green House spaces	140000
Startup expenses	22500
Total present value of cash outflow	366500

Present value of Cash inflow:

Particulars	Amount
Sales	1369824
Variable costs	802420
Overheads	102453
Cumulative present value profit for 5 years	464951
Cumulative After tax present value profit for 5 years	413806
Total salvage values	158872
Total Cash inflows	572678

The total of the cash inflows is greater than the cash outflows.Hence the NPV of the project is positive. Therefore the contract can be accepted.The calculations are made assuming that the contract wont be renewed which is the worst case.Also working capital will be an inflow and outflow every year hene ignored assuming that the working capital is not borrowed but invested out of surplus funds available.