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

(b) Howden plc is contemplating investment in an additional production line to produce its range of compact discs. A market research study, undertaken by a well-known firm of consultants, has revealed scope to sell an additional output of 400,000 units p.a. The study cost £0.1 million, but the account has not yet been settled.

The price and cost structure of a typical disc (net of royalties) is as follows:

£ £

Price per unit Costs per unit of output Material cost per unit Direct labour cost per unit Variable overhead cost per unit Fixed overhead cost per unit Profit 1.50 0.50 0.50 1.50 12.00

(4.00)

8.00 The fixed overhead represents an apportionment of central administrative and marketing costs. These are expected to rise in total by £500,000 p.a. as a result of undertaking this project. The production line is expected to operate for five years and require a total cash outlay of £11 million, including £0.5 million of materials stocks.

The equipment will have a residual value of £2 million. Because the company is moving towards a JIT stock management policy, it is expected that this project will involve steadily reducing working capital needs, expected to decline at about 3 per cent p.a. by volume. The production line will be accommodated in a presently empty building for which an offer of £2 million has recently been received from another company. If the building is retained, it is expected that property price inflation will increase its value to £3 million after five years.

While the precise rates of price and cost inflation are uncertain, economists in Howden’s corporate planning department make the following forecasts for the average annual rates of inflation relevant to the project:

Retail Price Index Disc prices Material prices Direct labour wage rates Variable overhead costs Other overhead costs 6% p.a.

5% p.a.

3% p.a.

7% p.a.

7% p.a.

5% p.a.

Note: You may ignore taxes and capital allowances in this question.

Required

(a) Given that Howden’s shareholders require a real return of 8.5 per cent for projects of this degree of risk, assess the financial viability of this proposal.

(b) Briefly discuss how inflation may complicate the analysis of business financial decisions.