You are interested in an investment project that costs $7,500 initially. The investment has a 5-year horizon and promises future end-of- year cash inflows of $2,000, $2,000, $2,000, $1,500, and $1,500, respectively. Your current opportunity cost is 6.5% per year. However, the Fed has stated that inflation may rise by 1% or may fall by the same amount over the next 5 years.
Assume a direct positive impact of inflation on the prevailing rates (Fisher effect) and answer the following questions.
a. What is the net present value (NPV) of the investment under the current required rate of return?
b. What is the net present value (NPV) of the investment under a period of rising inflation?
c. What is the net present value (NPV) of the investment under a period of falling inflation?
d. From your answers in a, b, and c, what relationship do you see emerge between changes in inflation and asset valuation?