Edward Laren, an accountant with Tenergy Industries, prepared the following analysis of an investment in manufacturing equipment:Cost savings:
Labor savings ..................$500.000
Reduction in rework materials..............$125,000
Other........................$60,000
Total......................$685,000
Additional taxes related to cost savings..........$239,750
Tax savings related to depreciation of new equipment...$161,000
Annual cash flow................... $606,250
Present value at 10 percent for five years.........$2,298,173
Cost of equipment..................$2,300,000
Net present value..................$1,827
Edward's boss, Megan Mangione, reviewed the calculation and made the following bservation:Ed, you've assumed that there won't be inflation, but inflation is built into our 10 percent cost of capital. I think it 's reasonable to assume that labor and costs other than depreciation will increase by 4 percent per year. Why don't you redo the analysis with that assumption?
Required:
a. What does Megan Mangione mean by inflation to our 10 percent costs of capital?
b. Redo Edward Larne 's analysis assuming an inflation rate of 4 percent. Should the company make the investment in the equipment?