Advanced: Adjusting cash flows for inflation and the calculation of NPV and ROI The general manager of the nationalized postal service of a small country, Zedland, wishes to introduce a new service. This service would offer same-day delivery of letters and parcels posted before 10 am within a distance of 150 kilometres. The service would require 100 new vans costing $8000 each and 20 trucks costing $18000 each. 180 new workers would be employed at an average annual wage of $13 000 and five managers at average annual salaries of $20000 would be moved from their existing duties, where they would not be replaced.

Two postal rates are proposed. In the first year of operation letters will cost $0,525 and parcels $5.25. Market research undertaken at a cost of $50000 forecasts that demand will average 15 000 letters per working day and 500 parcels per working day during the first year, and 20000 letters per day and 750 parcels per day thereafter. There is a five day working week. Annual running and maintenance costs on similar new vans and trucks are currently estimated in the first year of operation to be $2000 per van and $4000 per truck respectively. These costs will increase by 20% per year (excluding the effects of inflation). Vehicles are depreciated over a five year period on a straight-line basis. Depreciation is tax allowable and the vehicles will have negligible scrap value at the end of five years. Advertising in year one will cost $500000 and in year two $250000. There will be no advertising after year two. Existing premises will be used for the new service but additional costs of $150000 per year will be incurred.

All the above cost data are current estimates and exclude any inflation effects. Wage and salary costs and all other costs are expected to rise because of inflation by approximately 5% per year during the five year planning horizon of the postal service. The government of Zedland will not permit annual price increases within nationalized industries to exceed the level of inflation.

Nationalized industries are normally required by the government to earn at least an annual after tax return of 5% on average investment and to achieve, on average, at least zero net present value on their investments.

The new service would be financed half with internally generated funds and half by borrowing on the capital market at an interest rate of 12% per year. The opportunity cost of capital for the postal service is estimated to be 14% per year. Corporate taxes in Zedland, to which the postal service is subject, are at the rate of 30% for annual profits of up to $500 000 and 40% for the balance in excess of $500 000. Tax is payable one year in arrears. All transactions may be assumed to be on a cash basis and to occur at the end of the year with the exception of the initial investment which would be required almost imme¬ diately.

Required:

(a) Acting as an independent consultant prepare a report advising whether the new postal service should be introduced. Include in your report a discussion of other factors that might need to be taken into account before a final decision was made with respect to the introduction of the new postal service.

State clearly any assumptions that you make. (18 marks)

(b) Monte Carlo simulation has been suggested as a possible method of estimating the net present value of a project. Briefly assess the advantages and disadvantages of using this technique in investment appraisal. (7 marks)

(Total 25 marks) ACCA Level 3 Financial Management