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Investment AppraisalSection CInvestment AppraisalNPVInflation

ACCA · Question 31 · Investment Appraisal

Section C

OrbitLogix PLC is a commercial space-tech company evaluating a project to deploy a new network of low-earth orbit satellites. The project requires an immediate capital investment of $120 million for satellite manufacturing and launch vehicles.

The project is expected to generate the following real (current price) cash flows before tax:
Year 1: $30 million
Year 2: $45 million
Year 3: $55 million
Year 4: $40 million

At the end of Year 4, the satellites will be decommissioned. The decommissioning cost is estimated at $15 million in real terms.

Additional Information:

  1. General inflation is expected to be 4% per year. All real cash flows (including decommissioning) will inflate at this general rate.
  2. Tax-allowable depreciation (capital allowances) is available on the initial $120m investment at 25% per year on a reducing balance basis. A balancing allowance or charge will arise in Year 4 when the assets are scrapped for zero value.
  3. Corporate tax is 20%, payable in the year the profit is generated.
  4. The project requires an initial working capital investment of $10 million, which will increase by inflation each year. The total working capital will be fully recovered at the end of Year 4.
  5. OrbitLogix has a nominal after-tax cost of capital of 12%.

Required:
(a) Calculate the nominal Net Present Value (NPV) of the satellite project and recommend whether it should be accepted. (15 marks)
(b) Discuss the concept of 'Real Options' in investment appraisal and identify two real options that OrbitLogix might possess in relation to this project. (5 marks)

How to approach this question

For Part A: Set up a standard NPV spreadsheet format. 1) Inflate the real cash flows to nominal using 1.04^n. 2) Calculate tax on these nominal flows. 3) Calculate Tax Allowable Depreciation (TAD) at 25% reducing balance, find the tax savings, and put the balancing allowance in Year 4. 4) Calculate working capital increments (inflating the base each year) and recover the total in Year 4. 5) Sum the net cash flows and discount at the nominal rate of 12%. For Part B: Define real options as managerial flexibility. Relate specific options (expand, delay, abandon) to the space-tech scenario.

Full Answer

This is a comprehensive investment appraisal question requiring the nominal approach. Because the discount rate provided (12%) is nominal, all cash flows must be converted to nominal terms by applying inflation. Tax allowable depreciation provides a tax shield; because the asset is scrapped for zero, the remaining tax written down value in Year 4 becomes a balancing allowance. Working capital increases with inflation, requiring small cash outflows each year, with the entire accumulated balance recovered at the end.

Common mistakes

Discounting real cash flows with a nominal discount rate. Forgetting to calculate the balancing allowance in the final year. Treating the total working capital balance as a cash outflow each year instead of just the incremental increase.
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