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Effect of inflation/working capital on cash flows

The company's financial manager and account 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 governments 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 firms expected borrowing rate from its bank of 10 percent, its estimated cost of equity of 15 percent, and a 25 percent corporate tax rate. Who is correct in this argument? Please elaborate.

Reviewing the cash flow forecast of new investment project that appear in the table below ,the Avon company's fiance manager noted that there was no mention of any effect of the investment on the firms account receivable and payable.The average collection period on the new product was expected to be 50 days, and new raw material purchases were expected to be settled in 36 days on average.Also he noted that the standard charges of 1 percent sales revenues from new projects had not been made,nor the annual financing charge of 10 percent levied against the books value of the assets used by the project.How would the projects profitability be affected by including its effect on Avons:

a. accounts receivable and accounts payable
b.overhead costs
c.financial manager

Now Year1 to 4 5 years
1. Revenues 12,000 12,000
2. Raw materials 4,000 4,000
3.Direct costs 1,000 1,000
4.Depreciation expense 4,000 4,000
5.Pre tax operating profit 3,000 3,000
6.Tax rate 40% 40%
7.After tax operating profit 1,800 1800
8. Increase in inventories 400.00 0 - 400
9.Capital expenditures 20,000 0 0
10.After tax resale value of equip 0
11.Cash flow from project -20,4000 5,800 6,200
12Net present value of project at $1,274
11% cost of capital

Solution Preview

1. The financial manager is correct. The cost of debt and equity would include the inflation effects since these would be nominal rates. The bank interest rate would account for inflation since the bank when it raised cash from depositors, the depositors would also want to be compensated for inflation and the so the deposit rate of bank would be including inflation. In the same way the lending rate would also be after including inflation.
In the same way, ...

Solution Summary

The solution explains the effect of inflation and change in working capital on cash flows