Calculate the real cost of capital


Problem: A company is evaluating two mutually exclusive projects B and C, each having a useful life of 3 years. B requires an immediate capital outlay of £1.2m while C required £1m. In the absence of cost and price inflation, the cash flows shown in the following table would remain constant throughout the life of the each project and arise at the end of each of the next three years.

Cash Flows

B £

C £

Cash inflow from sale

1,000,000

800,000

Cash outflows

 

 

Labour

200,000

100,000

Materials

200,000

50,000

Other

20,000

150,000

 

(420,000)

(300,000)

Net cash flows

580,000

500,000


However, it is now predicted that sales prices will increase by 10% p.a., labour costs by 20%, and material costs by 8%. The money cash flows of other costs are:

Project

Yr 1

Yr 2

Yr 3

B

21,000

44,000

88,720

C

158,000

206,000

265,000


The nominal cost of capital is estimated to be 15% p.a.

Question 1: Using the NPV method, determine which project is financially more attractive.

Question 2: If the RPI is expected to increase by 10% p.a., calculate the real cost of capital.

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Finance Basics: Calculate the real cost of capital
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