Explain how inflation affects the rate of return required

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Reference no: EM131365372

FINANCIAL MANAGEMENT

The Directors of M&R Plc wish to expand the Company's operations.However; they are not prepared to borrow at the present time to finance capital investment. The Directors have therefore decided to use the company's cash resources for the expansion programme.

Three possible investment opportunities have been identified. Only £600,000 is available in cash and Directors intend to limit the capital expenditure over the next 12months to this amount. The projects are not divisible and none of them can be postponed.

The following cash flows do not allow for inflation, which is expected to be 12% per annum constant for the foreseeable future.

Expected net cash flows (including residual values)

	INITIAL INVESTMENT	YEAR 1	YEAR 2	YEAR 3
PROJECT	£	£	£	£
A	-310,000	96,000	113,000	210,000
B	-115,000	45,000	42,000	47,000
C	-36,000	-41,000	-23,000	127,000

The company's shareholders currently require a return of 16% nominal on their investment. Ignore taxation required.

a) Explain how inflation affects the rate of return required on an investment project and the distribution between a real and a nominal approach to the evaluation of an investment project under inflation.

b) i.Calculate the expected net present value and profitability indexes of the three projects; and

ii. Comment on which project(s) should be chosen for the investment, assuming the company can invest surplus cash in the money market at 10%.

c) Discuss whether the company's decision not to borrow, thereby limiting investment expenditure, is in the best interests of its shareholders.

Reference no: EM131365372

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