Chapter 6, Problem 7PS

Real and nominal flows Guandong Machinery is evaluating a new project to produce encapsulators. The initial investment in plant and equipment is RMB 500,000.¹⁵ Sales of encapsulators in year 1 are forecasted at RMB 200,000 and costs at RMB 100,000. Both are expected to increase by 10% a year in line with inflation. Profits are taxed at 25%. Working capital in each year consists of inventories of raw materials and is forecasted at 20% of sales in the following year. The project will last five years and the equipment at the end of this period will have no further value. For tax purposes the equipment can be depreciated straight-line over these five years. If the nominal discount rate is 15%, show that the net present value of the project is the same whether calculated using real cash flows or nominal flows.