(a) Explain how inflation affects the rate of return required on an investment project, and also explain the distinction between a real and a nominal (or ‘money terms') approach to the evaluation of an investment project under inflation.

(b) Your company has under review a project involving the outlay of $137 500. Cumulative working capital requirements, in real or current terms will be $20 000 in year 0; $30 000 in year 1; $35 000 in year 2; $40 000 in year 3 and $40 000 in year 4. The project is expected to yield the following net post-tax cash operating savings in real or current terms:

Year$

1 40 000

2 60 000

3 80 000

4 20 000

The company's cost of capital, incorporating a requirement for growth in dividends to keep pace with cost inflation, is 20 per cent, and this is used for the purpose of investment appraisal. On the above basis, the divisional manager involved has recommended rejection of the proposal.

i) Given your own forecast that selling prices and overhead expenses are likely to increase by 20 per cent in year 1; 15% in year 2, 12% in year 3 and 10 per cent in year 4; and that working capital requirements will increase by 7% per annum over the life of the project, you are asked to comment fully on his recommendation.

Hint.

Calculate the NPV according to the divisional manager and the NPV incorporating inflation levels to support your comments. In both cases, assume the total investment in working capital will be recovered at the end of the project.

ii) Calculate the Internal Rate of Return, the discounted payback period and the profitability index of the project after incorporating inflation to the cash-flows.