Forecast sales volume is 300,000 units per year, increasing by 50,000 units per year, and the investment project is expected to last for four years.
Inflated selling prices
Year 1: 5.30 x 1.05 = $5.57 per unit
Year 2: 5.30 x 1.052 = $5.84 per unit
Year 3: 5.30 x 1.053 = $6.14 per unit
Year 4: 5.30 x 1.054 = $6.44 per unit
Inflated sales revenue
Year 1: 5.57 x 300,000 = $1,671,000
Year 2: 5.84 x 350,000 = $2,044,000
Year 3: 6.14 x 400,000 = $2,456,000
Year 4: 6.44 x 450,000 = $2,898,000
Inflated variable costs
Year 1: 3.15 x 1.04 = $3.28 per unit
Year 2: 3.15 x 1.042 = $3.41 per unit
Year 3: 3.15 x 1.043 = $3.54 per unit
Year 4: 3.15 x 1.044 = $3.69 per unit
Using year 2 inflated costs as an example, when performing these calculations in a spreadsheet the following methods can be used
=3.15*1.04^2
=3.15*POWER(1.04,2)
There are other methods of calculating these figures and any approach which gives the correct figures will be given credit in the exam.
Inflated total variable cost
Year 1: 3.28 x 300,000 = $984,000
Year 2: 3.41 x 350,000 = $1,193,500
Year 3: 3.54 x 400,000 = $1,416,000
Year 4: 3.69 x 450,000 = $1,660,500
Nominal terms total contribution
Year 1: 1,671,000 – 984,000 = $687,000
Year 2: 2,044,000 – 1,193,500 = $850,500
Year 3: 2,456,000 – 1,416,000 = $1,040,000
Year 4: 2,898,000 – 1,660,500 = $1,237,500
Real cash flows
Real cash flows are found by deflating nominal cash flows by the general rate of inflation.
Example of calculating real cash flows by deflating nominal cash flows
Using the nominal cash flows calculated above and a general rate of inflation of 4.8%:
Real terms total contribution
Year 1: 687,000/ 1.048 = $655,534
Year 2: 850,500/ 1.0482 = $774,376
Year 3: 1,040,000/ 1.0483 =$903,544
Year 4: 1,237,500/ 1.0484 = $1,025,888
Nominal terms approach to investment appraisal
The nominal terms approach to investment appraisal involves discounting nominal cash flows with a nominal cost of capital in calculating the NPV of an investment project.
Example of calculating nominal terms NPV
Using the nominal contributions calculated earlier, a nominal discount rate of 9.0% and an assumed initial investment of $1,000,000: