BURLEY PLC
Financial desirability
In a real-terms analysis the real rate of return necessary by shareholders has to be used. This is found as follows
1 nominal rate/1 inflation rate-1 = (1.14/1.055) -1 = 8%
The applicable operating costs per box after removing the allocated overhead are (8.00 + 2.00 + 1.50 + 2.00) = $13.50. The costs of the preliminary research etc are not relevant as they are sunk. The set-up cost has previously been adjusted for tax reliefs but the annual cash flows will be taxed at 33%.
The NPV of the project is given by
NPV($) = [PV of after-tax cash inflows] - [set-up costs]
= 0.15m [20 - 13.50] (1 - 33%) PVIFA8.5 - 2m
= 0.65m (3.993) - 2m
= + 2.6m - 2m
= + 0.6m i.e., + $0.6m
Therefore the project is attractive according to the NPV criterion.
The IRR is merely the discount rate R which generates a zero NPV that is the solution to the expression
NPV = 0 = 0.65m (PVIFAR,5) - 2m
Hence PVIFAR.5 = 2m/0.65 = 3.077
To the nearest 1% IRR = 19%. Ever since this exceeds the required return of 8% in real terms the project is acceptable.