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.
a. Using the NPV method, determine which project is financially more attractive.
b. If the RPI is expected to increase by 10% p.a., calculate the real cost of capital.