Inflation adjustments. The Laer Corporation is considering buying some machinery costing $800,000 to produce a new product.
The equipment is classified as a three year MACRS asset for tax purposes and is expected to have zero salvage value after four years. The sales manager expects sales over the next four years of 20,000 units per year.
The unit price the first year will be $45. Unit variable costs are initially $28; there are no other relevant costs.
The firm's nominal cost of capital is 18 percent, including a premium for expected inflation of 5 percent. The firm's tax rate is 40 percent.
If the price of the product and operating expenses both rise at the rate of inflation (5 percent) each year, what are the expected nominal operating cash flows? What is the NPV of the project?
Suppose competitions expected to keep the firm from raising prices any more than 3 percent per year to maintain the same sales volume.
Anticipated decreases in raw materials supplies is expected to cause operating expenses to rise by 6 percent per year.
Under these conditions, what are the nominal operating cash flows? What is the NPV of the project?