Question one. Calculate the adjusted present value (APV) for the project, correcting any errors made in the net present value estimate above, and conclude whether the project should be accepted or not. Show all relevant calculations. (25 marks)
Before any attempt should be made to prepare the adjusted present value of the proposed project, Rattle Co must carefully study how the given projected cash flow statement for four years was made, to know where some should remain because they are already correct or whether they need further adjustments. When the needed adjustments are known, the framework is established to do the same with each item in the prepared cash flows, asking whether it should be adjusted or not.
Starting with the revenue, it appears that one critical issue would be whether it should be presented with inflation or net of inflation. The answer would depend on what discount rate is used. If the discount rate is with inflation, then the revenue must include the inflation. In the case facts, the inflation was given however, if the discount rate is used with the real rate, i.e. not the nominal one, then presenting the net of inflation of the inflation rate is the proper thing. The 8% inflation rate increase for revenues and 4% inflation rate increase for cost of sales become irrelevant.
Working capital requirements appear not to be reflected in the given cash flow. These need to be determined, as they are a factor in any decision. A business cannot operate without working capital. Since the amount of working capital at the beginning of each year is 20% of the forecasted revenue per year, just multiply each given sales figure per year, then it is possible to generate a working capital requirement per year.
As computed in the revised and adjusted projected cash flow in Appendix A, the working capital amounts come to £4,606,000, £7,320,000, £9,814,000 and £5,428,000 for