NPV and real cost
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A company is evaluating two mutually exclusive projects B and C, each having a useful life of 3 years. B requires an immediate capital outlay of £1.2m while C required £1m. In the absence of cost and price inflation, the cash flows shown in the following table would remain constant throughout the life of the each project and arise at the end of each of the next three years.
Cash Flows B £ C £
Cash inflow from sale 1,000,000 800,000
Cash outflows
Labour 200,000 100,000
Materials 200,000 50,000
Other 20,000 150,000
(420,000) (300,000)
Net cash flows 580,000 500,000
However, it is now predicted that sales prices will increase by 10% p.a., labour costs by 20%, and material costs by 8%. The money cash flows of other costs are:
Project Yr 1 Yr 2 Yr 3
B 21,000 44,000 88,720
C 158,000 206,000 265,000
The nominal cost of capital is estimated to be 15% p.a.
a. Using the NPV method, determine which project is financially more attractive.
b. If the RPI is expected to increase by 10% p.a., calculate the real cost of capital.
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NPV and real costs are evaluated.
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