Question 1: If the annual cash flows and salvage value in Exhibit were subject to inflation at the annual rate of 4%, the cash flows would be those shown below. (Note that, under these conditions, the annual depreciation is now approximately $11,556.69 [($70,000 - $12,166.53)/5)] Assume all cash flows except for the purchase occur at the end of the year.
|
Time
|
Amount
|
Depreciation
|
Taxable Income
|
Tax at 40%
|
Net cash flow
|
|
0
|
($70,000)
|
|
|
|
($70,000)
|
|
1
|
20,800
|
11,566.69
|
9,233.31
|
3,693.32
|
17,106.68
|
|
2
|
21,632
|
11,566.69
|
10,065.31
|
4,026.12
|
17,605.88
|
|
3
|
22,497.28
|
11,566.69
|
10,930.59
|
4,372.23
|
18,125.05
|
|
4
|
23,397.17
|
11,566.69
|
11,830.48
|
4,732.19
|
18,664.98
|
|
5
|
36,499.59
|
11,566.69
|
12,766.36
|
5,106.55
|
31,393.04
|
However, with inflation, the required rate of return must be increased so that it will provide for both the time value of money and the purchasing power loss due to inflation. In general, the required rate of return is as follows:
(1 + required rate of return) = (1 + real rate of interest) x (1 + inflation rate)
Required rate of return = (1 + real rate of interest) x (1 + inflation rate) – 1
Required rate of return = real rate of interest + inflation rate + (real rate of interest x inflation rate)
Where the real rate of interest is the return required in the absence of inflation.
A. Using the appropriate required return, compute the project’s net present value.
B. Why is the net present value of the project lower under conditions of inflation than it was without inflation?
Below is the original copy of exhibit:
|
Time
|
Cash Flow
|
Depreciation
|
Taxable Income
|
Tax @ 40%
|
Net cash flow
|
|
0
|
($70,000)
|
|
|
|
($70,000)
|
|
1
|
20,000
|
12,000
|
8,000
|
3,200
|
16,800
|
|
2
|
20,000
|
12,000
|
8,000
|
3,200
|
16,800
|
|
3
|
20,000
|
12,000
|
8,000
|
3,200
|
16,800
|
|
4
|
20,000
|
12,000
|
8,000
|
3,200
|
16,800
|
|
5
6
|
20,000
10,000
|
12,000
0
|
8,000
0
|
3,200
0
|
16,800
10,000
|