You are interested in an investment project that costs $40,000 initially. The investment has a 5-year horizon and promises future end-of-year cash inflows of $12,000, $12,500, $11,500, $9,000, $8,500 respectively. Your current opportunity cost is 6.5% per year. However, the Fed has stated that inflation may rise by 1.5% or may fall by the same amount over the next 5 years. Assume a direct positive impact of inflation on the prevailing rates (Fisher effects) and answer the following questions. (Assume that inflation has an impact on the opportunity cost, but that the cash flows are contractually fixed and are not affected by inflation).
a) What is the NPV of the investment under the current required rate of return?
b) What is the NPV of the investment under a period of rising inflation?
c) …………………………………….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 evaluation?