Economics and financial managment

Economics and financial managment

Use excel spreadsheet to complete this assignment
Assignment 9: Cash Flow Statement
The manufacturing manager for Modern Manufacturing Company is working on a justification for implementing a “Lean/Just-in-time” manufacturing system. No upfront investment will be needed. No revenue changes are forecasted. A team of employees will spend their time training employees and making process changes. The salaries and benefits of the “Just-in-time” staff are shown below for the three years of the project.

A team of employees will spend their time training employees and making process changes. The salaries and benefits of the “Just-in-time” staff are shown below for the three years of the project. There will not be any change in other S.G.&A. expenses.

Financial gains are expected to be a reduction in the following areas: cost of good sold, inventory, and accounts payable. The data is shown below where each year changes from the previous year by the percentages shown.

Determine the present worth of the project to see if the savings justify the costs.

Week 9: Project Cash Flows
1. Generic Template
Last week a generic template for Income statements was presented. This is expanded this week to include a cash flow statement segment and a working capital worksheet. Note that “generic” just means that it is a good starting point for proposals. Alterations may be needed to fit a particular proposal.
Year
Income Statement     0     1     2     3     4     5
Revenue
Net Sales (Revenue)
Direct Costs
Labor
Material
Overhead
Cost of Goods Sold (COGS)
Gross Margin
Selling General and Admin.
Marketing
Research and Development
Administration
Other
Depreciation
S G & A
Earnings Before Interest and Taxes (EBIT)
Income Tax
Net Income

Free Cash Flow     0     1     2     3     4     5
Net Income
Depreciation (add back)
Investment
Salvage Value
Tax on Gain
Change in Working Capital
Free Cash Flow

PW of Proposal
Internal Rate of Return

Working Capital Worksheet     0     1     2     3     4     5
Inventory
Accounts Receivable
Accounts Payable
Total
Change in Working Capital
Keep the following in mind when preparing financial justifications.
•?All data is considered as “end of period” and the end of one period is equivalent to the start of the following period.
•?Year 0 contains upfront investment made before operations start and nothing else, and only in the cash flow statement,
•?Investments can be made upfront in year 0 or in other years in which the investment is actually paid (in which cash flows),
•?Actual project starting dates within a year may be anytime during the year, not only January 1.
2. Free Cash Flow
A statement of Free Cash Flow and the associated Working Capital Worksheet are critical for proposal evaluations. The income statement for a proposal shows how a proposal will affect the income from operations, including revenues, variable costs and fixed costs and provides the starting amounts for the cash flow. But the evaluation of a proposal also has to consider non-cash transactions (depreciation) and the effects of investments, salvage, and changes in working capital (inventory, accounts receivable and accounts payable). This is the role of the cash flow statement.
The NBPS case will be used to illustrate the line items on the cash flow statement, which is shown below the NBPS Income statement from last week.
Free cash flow starts with the earnings (Net Income) from the Income Statement for the proposal, that is, earnings enabled by the proposal. The NBPS Net Income is copied from the bottom line of the Income statement to the top line of the Cash Flow statement. Thus, the Income statement from last week is the starting point and follows.
Income Statement –
Year     0     1     2     3     4     5
Revenue Electronic         $10,000,000     $11,500,000     $13,225,000     $15,208,750     $17,490,063
Lost Revenue Printed         ($8,000,000)     ($15,360,000)     ($22,131,200)     ($28,360,704)     ($34,091,848)
Net Revenue         $2,000,000     ($3,860,000)     ($8,906,200)     ($13,151,954)     ($16,601,785)
COGS Electronic         ($4,000,000)     ($4,600,000)     ($5,290,000)     ($6,083,500)     ($6,996,025)
Reduced COGS Printed         $5,600,000     $10,752,000     $15,491,840     $19,852,493     $23,864,293
COGS         $1,600,000     $6,152,000     $10,201,840     $13,768,993     $16,868,268
Gross Margin         $3,600,000     $2,292,000     $1,295,640     $617,039     $266,483
General & Administrative
Service Cost         ($250,000)     ($250,000)     ($250,000)     ($250,000)     ($250,000)
Depreciation         ($1,000,000)     ($1,600,000)     ($960,000)     ($576,000)     ($576,000)
EBIT         $2,350,000     $442,000     $85,640     ($208,961)     ($559,517)
Taxes         ($705,000)     ($132,600)     ($25,692)     $62,688     $167,855
Net Income         $1,645,000     $309,400     $59,948     ($146,273)     ($391,662)

Free Cash Flow
0     1     2     3     4     5
Net Income         $1,645,000     $309,400     $59,948     ($146,273)     ($391,662)
Depreciation (add back)         ??     ??     ??     ??     ??
Investment     ??
Salvage Value                         ??
Tax on Gain                         ??
Change in Working Capital         ??     ??     ??     ??     ??
Free Cash Flow         ??     ??     ??     ??     ??
3. Depreciation and Investment
Next the depreciation is added back into to these earnings since depreciation does not involve any cash flow. Also the investment amount is entered in the period in which the investment funds are actually spent. Essentially, this is a swap of the depreciation amount for investment amount. The value of the investment is deducted from cash and the depreciation is added. This is not necessarily an equal swap. In the NBPS case, not all the depreciation was deducted in the five year span of the proposal. (recall only half the depreciation was taken in year 5, and none of year 6).
Free Cash Flow
0     1     2     3     4     5
Net Income         $1,645,000     $309,400     $59,948     ($146,273)     ($391,662)
Depreciation (add back)         $1,000,000     $1,600,000     $960,000     $576,000     $576,000
Investment     ($5,000,000)
Salvage Value                         ??
Tax on Gain                         ??
Change in Working Capital         ??     ??     ??     ??     ??
Free Cash Flow         ??     ??     ??     ??     ??
4. Salvage and Book Value
Next, any cash changes from salvage value effects are recorded. This can be from sales of the asset at the end of its life (salvage value), or costs incurred for cleanup (salvage cost). It also can be a valuation of the asset at the end of the proposal time span. Associated with this are taxes on the gains, or losses on the salvage value. This is determined as follows.
4.1. Salvage Value and Tax on Gain
Salvage value was mentioned last week in conjunction with depreciation. When straight-line depreciation is used, it is deducted from the upfront investment. But since salvage of an asset involves the flow of cash, it has its own line in the Free Cash Flow statement. If a asset can be sold, its value needs to be recorded in the period in which cash will be received no matter what type of depreciation is used.. If a salvage cost is involved such as cleanup, etc., it should be recorded as negative. Sometimes, both can occur.
If an investment results in an asset that has value at the end of the planning period, this value should be recorded as it could be sold. For instance, if new stores are opened, or patents were granted that could be sold, they have value at the end of the project that needs to be included in the evaluation. This does not mean that the asset has to be sold, just that its value gained from the project needs to be included. That is, the salvage value in proposals can be an opportunity cost if the asset is not sold or retired during the proposal’s time span.
4.2. Book Value
Salvage value is income and therefore has tax considerations. The tax is based on the gain/loss on the difference between the salvage value and the book value. The book value is the difference between the investment value and all depreciation that has been deducted in the Income statement.
Some states have a capital gains tax rate which should be used for this gain or loss since this is a gain or loss in a capital expenditure. If this is not available, the income tax rate is used.
Several examples below will be used to illustrate this. In these examples, an asset with a value of $1,000 is assumed and using 5-year MACRS depreciation. In the first example using a 6 year time horizon, a salvage value of $100 is forecasted to be received in year 6 and is recorded there.
The book value is determined by deducting the depreciation in each year from the investment amount. In year one, $200 of depreciation is subtracted from $1,000 investment giving $800. In year 2, $320 of depreciation is subtracted from this $800 giving $480, and so one for the remaining years of the time horizon until the book value is zero in year 6. In this example with a book value of zero, the capital gain is the full $100 salvage value. With a tax rate of 30%, a tax of $30 would be subtracted in the cash flow statement as shown below.
Example 1:     Salvage value in year 6 =     $100
Year     0     1     2     3     4     5     6
Investment     $1,000
Depreciation- 5 MACRS         20%     32%     19.20%     11.52%     11.52%     5.76%
Depreciation $         ($200)     ($320)     ($192)     ($115)     ($115)     ($58)
Book Value         $800     $480     $288     $173     $58     $0
Gain                             $100
Cash Flow statement entries:
Salvage Value                             $100
Tax on gain (30%)                             ($30)
In the second example below assume that the asset is sold in year 5 for $300. First the depreciation in year five has to be reduced by 50% since only half of the depreciation can be claimed for a 5 year asset if it is sold in five or less years.
The book value for each year is shown by deducting the depreciation from the previous year’s book value as explained in example 1. Then the gain in year 5 is determined by subtracting the $155 book value from the $300 salvage value to show a capital gain of $185. Multiplying this by the 30% tax rate (and -1) results in taxes of -$55 that is recorded in the cash flow statement. Note that the full $300 salvage value is recorded as income. The book value is only used to determine the tax on the gain or loss.
Example 2     Salvage value in year 5 =     $300
Year     0     1     2     3     4     5
Investment     $1,000
Depreciation- 5 MACRS         20%     32%     19.20%     11.52%     11.52%
Depreciation $         ($200)     ($320)     ($192)     ($115)     ($58)     50% rule
Book Value         $800     $480     $288     $173     $115
Gain                         $185     300 – 115
Cash Flow statement entries:
Salvage Value                         $300
Tax on gain (30%)                         ($55)
The third example is the same as the second except that the salvage value is only $100 and in year 4. Since it is being sold in year 4, the half or 50% rule is applied to the depreciation in year 4. The salve value of $100 minus the Book value of $230 results in a loss of -$130 that leads to a tax credit of $39. This is shown below.
Example 3     Salvage value in year 4 =     $100
Year     0     1     2     3     4     5
Investment     $1,000
Depreciation- 5 MACRS         20%     32%     19.20%     11.52%     11.52%
Depreciation $         ($200)     ($320)     ($192)     ($58)     50% rule
Book Value         $800     $480     $288     $230
Gain                     ($130)
Cash Flow statement entries:
Salvage Value                     $100
Tax on gain (30%)                 Credit     $39
The fourth example is for the situation where an asset will not be sold. But the asset was developed as part of the project and is retained. Therefore its value should be included as part of the value created by the project. In the last year of the time horizon, an estimate has to be made as to the value of the asset at that point. This is essentially a salvage value, although it will not be sold. So It is an opportunity cost or value in that it is the value if it was sold.
This is shown below. Since the asset will not be sold, the full depreciation is taken in year 5 and the book value then becomes $58. Subtracting this book value from the Opportunity (salvage) value yields a gain of $442 and a tax of -$133. Contrast this with example 2 where the asset was sold in year 5
Example 4     Not sold, but has an opportunity cost of $500 year 5 for a project with a 5 year time horizon.
Year     0     1     2     3     4     5
Investment     $1,000
Depreciation- 5 MACRS         20%     32%     19.20%     11.52%     11.52%
Depreciation $         ($200)     ($320)     ($192)     ($115)     ($115)
Book Value         $800     $480     $288     $173     $58
Gain
Cash Flow statement entries:
Salvage (Opportunity)Value                         $500
Tax on gain (30%)                         ($133)
A video segment that shows this is: Book Value, Gains and Taxes
5. Back to the NBPS case
The original NBPS case stated that there was no salvage value. This will now be changed to illustrate how it would affect the cash flow statement. Suppose that the investment is estimated to be worth $500,000 at the end of year 5.
First the Book value of the investment needs to be calculated. The depreciation was calculated earlier and repeated here, and since the electronic book asset is not sold, the 50% rule does not apply. The book value is determined in year 1 by subtracting the depreciation from the original investment in year 0 that is $5,000,000 minus $1,000,000 to give a book value of $4,000,000 at the end of year 1. The year 2 book value is calculated by deducting the year 2 depreciation of $1,600,000 from the book value in year 1 ($4,000,000) to get $2,400,000. This proceeds through year 5 to get a book value of $576,000.
A gain of $212,000 is calculated by subtracting the Book value from the Salvage value. Multiplying this by the NBPS 30% tax rate yields a tax debit of $63,600. This is recorded in the cash flow statement.
Year     0     1     2     3     4     5
Depreciation %         20.00%     32.00%     19.20%     11.52%     11.52%
Depreciation $         $1,000,000     $1,600,000     $960,000     $576,000     $576,000
Salvage Value                         $500,000
Book Value         $4,000,000     $2,400,000     $1,440,000     $864,000     $288,000
Gaim/loss                         $212,000
Free Cash Flow
0     1     2     3     4     5
Net Income         $1,645,000     $309,400     $59,948     ($146,273)     ($391,662)
Depreciation (add back)         $1,000,000     $1,600,000     $960,000     $576,000     $576,000
Investment     ($5,000,000)
Salvage Value                         $500,000
Tax on Gain                         ($63,600)
Change in Working Capital         ??     ??     ??     ??     ??
Free Cash Flow         ??     ??     ??     ??     ??
6. Working Capital
Working capital is defined as Current Assets (here primarily inventory and accounts receivable) minus Current Liabilities (here primarily accounts payable). Changes in working capital resulting from the proposal affect cash amounts in the organization and therefore these changes should be calculated and recorded in the cash flow statement.
Cash changes due to Working capital changes are most easily considered in a separate worksheet. It typically has lines for Inventory, Accounts Receivable and Accounts Payable. Since Accounts Payable is a liability, they are recorded as negative values. The three rows are summed to get the total working capital.
The purpose is to determine the cash flow change caused by the proposal. This change in each period is calculated by subtracting each period’s total from the previous period’s total. This is shown below where no change is needed in year 0 prior to the start of the proposal.
0     1     2
Inventory     $5,000     $5,500     $4,500
Accounts Receivable     $2,000     $2,000     $2,500
Accounts Payable     ($6,000)     ($5,500)     ($5,500)
Total     $1,000     $2,000     $1,500
Change in Working Capital         $1,000     ($500)
The Change in Working Capital line is then inserted in the cash flow statement but with opposite signs. An increase in working capital requires cash so the cash flow would be negative. Conversely, a reduction in working capital creates cash and so would be recorded as a positive cash flow.
If a proposal requires an increase in working capital prior to the project’s start (in year 0), the change would be recorded in year 0. For instance, introducing a new product often would require building inventory in year 0 before sales start in year 1. Since you do not have a year -1, you cannot calculate the change in working capital in year 0 by subtracting the value for year -1. You simply have to record the needed change in year 0. For instance, suppose in the following example that an increase of $750 of inventory was needed by the start of year 1, which is the same as the end of year 0. It would be recorded, not calculated as shown in the change in year 0 cell. The remaining years are calculated as discussed above.
0     1     2
Inventory     $5,000     $5,500     $4,500
Accounts Receivable     $2,000     $2,000     $2,500
Accounts Payable     ($6,000)     ($5,500)     ($5,500)
Total     $1,000     $2,000     $1,500
Change in Working Capital     $750     $1,000     ($500)
Working capital changes will now be illustrated using the NBPS case.
6.1. Free Cash Flow for NBPS
The NBPS example is now amended to include the following free cash flow considerations.
Inventory costs in year 0 are $10 million and are expected to decrease 5% annually since there will be fewer printed books sold and electronic books have little inventory. Accounts payable are presently $8 million and expected to decrease 2% per year. Accounts Receivables are presently at $7 million and are expected to decline 3% annually in the future.
The data block has this addition:
Inventory Decrease     5%     annually
Inventory Balance     $10,000,000     year 0
AR Decrease     3%     annually
AR Balance     7,000,000     year 0
AP Decrease     2%     annually
AP Balance     8,000,000     year 0
The calculations for the Change in Working Capital are shown in the following Working Capital worksheet. The total working capital is a summation of the requirements for inventory, accounts receivable and accounts payable.
The resulting change in working capital that is needed is calculated by subtracting each year’s total working capital from the previous years. It is the change in working capital that either requires or creates cash.
A reduction in working capital, as determined in all years of this proposal, results in additional cash and therefore is then recorded on the Cash Flow statement with a positive sign.
0     1     2     3     4     5
Inventory     $10,000,000     $9,500,000     $9,025,000     $8,573,750     $8,145,063     $7,737,809
Accounts Receivable     $7,000,000     $6,790,000     $6,586,300     $6,388,711     $6,197,050     $6,011,138
Accounts Payable     ($8,000,000)     ($7,840,000)     ($7,683,200)     ($7,529,536)     ($7,378,945)     ($7,231,366)
Total     $9,000,000     $8,450,000     $7,928,100     $7,432,925     $6,963,167     $6,517,581
Change in Working Capital         ($550,000)     ($521,900)     ($495,175)     ($469,758)     ($445,586)

The finished NBPS Cash Flow statement is shown below with the inclusion of changes in working capital. The free cash flow resulting from the proposal had now been determined.
Free Cash Flow
0     1     2     3     4     5
Net Income         $1,645,000     $309,400     $59,948     ($146,273)     ($190,062)
Depreciation (add back)         $1,000,000     $1,600,000     $960,000     $576,000     $288,000
Investment     ($5,000,000)
Salvage Value                         $500,000
Tax on Gain                         $22,800
Change in Working Capital         $550,000     $521,900     $495,175     $469,758     $445,586
Free Cash Flow     ($5,000,000)     $3,195,000     $2,431,300     $1,515,123     $899,485     $1,066,324
This complete the cash flow analysis and from this, the Net present Value for a MARR of 10% and an Internal rate of Return can be calculated as shown below. The project looks attractive.
MARR     10%
PW of Proposal     $2,328,682
Internal Rate of Return     32.51%
A video segment showing the capital gains tax and working capital calculations for NBPS is found at: Working Capital
7. No Investments- Cost reduction only
There are common situations where costs are reduced with little if any investment in new assets. Costs are expensed in the year they occur. Many quality improvement programs or inventory reduction projects require staff to be added and/or training programs to be conducted with the goal of reducing costs. Downsizing or outsourcing programs often have cost reductions only as well. When equipment is leased there is no investment since the leasing cost is recorded as a cost, not an investment. A Free Cash Flow analysis and the Present Worth provide the needed evaluation. The following example illustrates this.
The manufacturing manager for Modern Manufacturing Company needs a cost justification for implement a “Lean” manufacturing system. No upfront investment will be needed. Rather a team of 10 employees is proposed to spend the first two years of the project training employees and making process changes as needed. The salaries and benefits of the employees will total $800,000 annually. In years 3 and 4, three employees at $300,000 annually will compose a permanent “Lean” staff to make certain the gains are continued and improved upon.
Gains are expected in two primary areas to justify the added expense: Cost of Goods Sold (COGS) reduction and Inventory reduction. The COGS is presently $5,200,000 and is expected to decline by 5% per year. Inventory, now at $1,000,000, is forecast to diminish 20% a year. Accounts Payable is now and is expected to continue at 70% of the inventory value. There is not expected to be any change in Accounts Receivable due to this project. Savings in such areas as warehouse personnel, space and machinery will not be included in the inventory cost reductions.
Assume that the company has sufficient earnings that tax credits computed from negative gains (see years 1 and 2) by the project can be applied elsewhere in the company.
What is the present worth of the savings and costs of this project? The company uses an inflation adjusted MARR of 15%, a tax rate of 25% and a time span of 4 years.
The Data Block for this example is as follows.
JIT Team first two years     $800,000
JIT Team last 4 years     $300,000
COGS- Currently     $5,200,000
COGS-Reduction per year     5%
Inventory Current     $1,000,000
Inventory Reduction per year     20%
Time Span     4     Years
Accounts Receivable     no change
Accounts Payable     70%     Inventory
MARR     15%
Tax Rate     25%

Prior to preparing the Income Statement and Free Cash Flow Statement, the cost of goods sold calculations need to be performed. COGS starts at $5,200,000 and is reduced by 5% annually. Note that the COGS change is cumulative over the four years. That is, the reduction of costs in one year is carried over and added to the savings in following years.
Year     Current     1     2     3     4
COGS     $5,200,000     $4,940,000     $4,693,000     $4,458,350     $4,235,433
Change         $260,000     $247,000     $234,650     $222,918
Cumulative Change         $260,000     $507,000     $741,650     $964,568
With this, this Income Statement can be prepared.
Revenue Change         $0     $0     $0     $0
COGS Change (from above)         $260,000     $507,000     $741,650     $964,568
Gross Profit         $260,000     $507,000     $741,650     $964,568
Just-in-Time Team Expense         ($800,000)     ($800,000)     ($300,000)     ($300,000)
Depreciation         $0     $0     $0     $0
EBIT         ($540,000)     ($293,000)     $441,650     $664,568
Taxes         $135,000     $73,250     ($110,413)     ($166,142)
Net Income (Attributable to JIT program)     ($405,000)     ($219,750)     $331,238     $498,426
To prepare the Free Cash Flow Statement, we first need a working capital worksheet to determine the3 changes in working capital each year.
Working Capital
Inventory     $1,000,000     $800,000     $640,000     $512,000     $409,600
Accounts Receivable         $0     $0     $0     $0
Accounts Payable     ($700,000)     ($560,000)     ($448,000)     ($358,400)     ($286,720)
Total     $300,000     $240,000     $192,000     $153,600     $122,880
Change in Working Capital         $60,000     $48,000     $38,400     $30,720
And finally, we prepare the Free Cash Flow Statement, which in this case shows a Present Worth of $115,716 for the four year proposal. Since there are no investments, an IRR is not computed. The positive PW suggests that the project should be approved.
Net Income         ($405,000)     ($219,750)     $331,238     $498,426
Depreciation         $0     $0     $0     $0
Investment
Salvage Value
Tax on Gain
Change in Working Capital     $60,000     $48,000     $38,400     $30,720
Free Cash Flow         ($345,000)     ($171,750)     $369,638     $529,146
Present Worth     $115,716
A video segment covering the Cost-Only situation is: Cost-Reduction
In preparing the statements for a cost only situation such as this, it works well to temporary assume and record some fictitious revenue. This makes the signs of costs such as depreciation taxes, etc. look reasonable and makes it easier to catch errors. When everything is in order, then the Revenue can be set back to zero.
8. Concluding Comments on Cash Flow
Income Statements and Free Cash Flow statements provide a rationale and convenient means to evaluate proposals. No two situations are the same and the statement formats need to be altered to fit each proposal.
It should also be kept in mind that most of the data are forecasts of the future and subject to error and risks. Next week we will look at analyses that look at the effects in variation of the assumed data. This is also relevant to corporate financial planning where alternative strategies are being considered.
9. Chapter 11: Inflation
Inflation often reminds me of the saying usually attributed to Mark Twain, “while everybody talks about the weather, nobody seems to do anything about it.” I wrote a paper in high school about 50 years ago on inflation when it was a major concern and I suspect it could be turned in today with just a few historical updates. The reason for this is that inflation is very complex, something like the weather.
Inflation is related to the money supply, to supply and demand of resources, to technology change, to market competition, to governmental actions, to economies around the world, to psychology and mass hysteria, and even to the weather (due to crop failures etc.). Chapter 11 presents many concepts and issues.
Sometimes inflation is explicitly considered in proposal analyses and sometimes it is ignored. This is determined by company policy or tradition.
Inflation is difficult to predict with any accuracy and some research suggest it is included in APRs. “Fisher’s Effect” states that nominal interest rates (APRs) have inflation factored into them. Research to test this has been conducted on past data to see if inflation rates were correlated with nominal interest rate changes. These studies tend to confirm this but are not conclusive. And these are correlation studies, not casual ones. But in general, nominal interest rates may unconsciously include forecasted inflation.
Inflation can be considered in project financial analyses. There are two basic ways to do this. One is to factor it into the computation of the MARR. That is, add an estimate of inflation to the cost of capital and risk factor. The other is to factor it into the income and cash flow statements. Here we will look only at the first approach.
9.1. Inflation Adjusted MARR
As we saw with the Time Value of Money equations, compound interest rates are computed using (1+r)^n -1. For instance, two years with an APR of 5% yields a combined rate for two years of
1 + rate = (1+5%)^2
=(1+5%)*(1+5%)
= 10.25%.
If the first year was 5% and the second year 8%, it would be
1 + rate = (1+5%)*(1+8%)
= 1+13.4%.
The same logic can be used to include the inflation rate in a MARR. The general equation is:
1+ MARR = (1+ Rate)*(1+ Inflation Rate)
Multiplying out the right side and subtracting 1 from both sides of the equation yields:
MARR = Rate + Inflation Rate + (Rate * Inflation Rate)
For a rate of 10% and an inflation rate of 3%, the combined rate computes to:
MARR = 10%+3%+10%*3%
= 10% + 3% + 0.3%
= 13.300%
So to include the 3% inflation rate, a desired rate of 10% MARR should be increased to 13.3% to compensate for forecasted inflation.
Inflation forecasts are not accurate and project proposals include many estimates, so if the inflation rate is small (<10%), the calculations often are simplified to the following:
MARR = Rate + Inflation
= 10% + 3% = 13%
The last term of 3% * 10% = .03%, which is negligible.
The converse of this is the question of what would an investment that is forecasted to return say 10% annually, really earn if there was 2% inflation. Accurately, this should be calculated as:
Real Return = (Nominal rate – inflation rate) / (1 + inflation rate)
=(10%-2%)/(1 + 2%)
= 8%/.98
=7.84%
More commonly it is simplified to:
= 10% – 2% = 8.00%
9.2. Inflation Indexes
Inflation is measured using indexes that indicate the change in the value of particular currencies. These are determined by selecting a group of products and or services and observing the difference in prices at different points in time. If a group of products cost $100 last year and $104 this year, the index is 104/100 = 1.04. It is often just reported as 104 which means that prices are 104% higher than previous. Or multiply last year’s price by 104% to get this year’s price.
There are some problems inherent in this. The choice of products in an index obviously makes a difference. So many different indexes are available for different product or service groups. A conference question will address this.
A second issue is whether the product last year is the same as this year. Products are enhanced so comparison on price alone is not always accurate. Conversely, some product lose value, not because of deflation, but because a new product category makes them of less value. Creators of indexes try to compensate for this, but it quite difficult to do this accurately.
From a proposal financial analysis perspective, indexes become relative to choosing which inflation rate should be used. For costs, various producer cost indexes are important. For sales prices of consumer products, differing consumer price indexes may be relevant.
But when looking at the future, it must be remembered that inflation estimates are very inexact. For instance, in 2008-2009, many people were forecasting imminent inflation numbers above 10% due to Federal Reserve and Treasury department actions. There was a large flight of investments into gold, but the inflation has not happened. Maybe it will eventually, but investments in gold are no longer increasing like they were in the 2010-2011 timeframe meaning gold investments are no longer showing much of a return. Foreign competition and a lack of consumer demand probably have kept inflation relatively low.
10. Foreign Currency Exchange
Globalization is firmly entrenched in the business world today and proposals often times need to consider foreign currencies. This is not discussed in the Park textbook, but a short introduction will be made here. Consider a question as follows.
You have an investment opportunity in Germany that requires an investment of $250,000 today and will produce a cash flow of €208,650 in one year with no risk. Suppose the risk-free rate of interest is 5% and the current competitive exchange rate is €0.78 to $1.00. What is the NPV of this project? Would you take the project?
This requires the conversion or euros to dollars, or vice versa. If the exchange rate is stated as €0.78 to $1.00, $10 would be 10*€0.78 = 7.80 euros and €10.00 (10 Euros) would be 10/.78 = $12.82.
So in the above question, the €208,650 would be 206,650/.78 = $264,935.90 in dollars.
Alternatively the $250,000 could be converted to Euros by $250,000 * €0.78 = €195,000.
The discounting needed for the PV could be done in either currency using the 5% rate.
In Excel, the currency sign can be changed from $ to most any currency in the world. Right click and select “Format Cell”, select Number tab and currency, and note the drop down box for “Symbol”. But this is only a symbol; it does not do the conversion from one currency to another.
Almost all major financial sites have currency exchange rates. This one does the conversion: http://www.oanda.com/currency/table
Exchange rates for most currencies are determined by the open market and are bought and sold on exchanges like stocks. Forex is a currency exchange http://www.forex.com/ where this can be done, similar to the booths in international airports. Prices are a function of supply and demand like stocks. Some countries peg their currency to another countries currency, often the dollar. So if say the dollar changes in value in the open market, so does their currency and at the same rate. China does this. There are some benefits of this such as controlling inflation in developing economies, but it is generally considered counterproductive to the world economy.