Question
The Great Eastern Toy Company management is considering an investment in a new product. It would require the acquisition of a piece of equipment for
The Great Eastern Toy Company management is considering an investment in a new product. It would require the acquisition of a piece of equipment for $16 million with a ten-year operational life, providing regular maintenance is carried out. Salvage value of the equipment is estimated at $800,000. The product's economic life is expected to be five years, with annual revenues estimated at $10.8 million during this period. Raw material for the new product is estimated at $95 per unit produced, and an inventory equivalent to one month's production, or 3,000 units, would be needed. Direct costs of manufacture are expected to be $130,000 per month. Work-in-progress and finished goods inventories would rise by $150,000. For tax purpose, fixed assets must be depreciated according to the straight-line method. The corporate income tax rate is 40 percent and so is the capital-gain tax rate. The company's cost of capital is 12 percent.
a. Based on the above data, set out the cash flows expected from the project (IN EXCEL with the formula).
b. What is the net present value of the project?
2. The effect of inflation on the investment decision.
The company's financial manager and accountant were arguing over how to properly take account of inflation when analyzing capital investment projects. The accountant typically included estimates of price-level changes when estimating and projecting future cash flows. For this, he took the government's gross domestic product (GDP) price deflator as the best estimate for the future inflation rate. This was 5 percent per year. He therefore believed that the company's discount rate should take into account inflation and that the standard 12 percent they used should be increased by 5 percent to avoid biasing the analysis and overestimating the net present value of the project. The financial manager disagreed, arguing that what the accountant was proposing would really underestimate the net present value. The 12 percent discount rate had been computed by taking the firm's 10 percent expected borrowing rate from its bank, its estimated cost of equity of 15 percent, and a 25 percent corporate tax rate.
Question: Who is correct in this argument? Please elaborate.
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