3. Inflation in project analysis A Aa It is often easy to overlook the impact of

Question

3. Inflation in project analysis A Aa It is often easy to overlook the impact of infation on the net present value of the project. Not incorporating the impact of inflation in determining the value of the cash flows of the project can result in erroneous estimations. Consider the following scenario: Widget Corp. is the first year of the project. The com however, it expects the selling price and cost per IToy to increase by 1% each year. considering opening a new division to make IToys that it expects to sell at a price of $14,800 each in year of the project. The company expects the cost of producing each iToy to be $7,225 in the first year; Based on this information, complete the following table: Selling price in year 4: cost per unit in year 4: $15,097 $14,948 $15,248 $15,401 If a company does not take inflation into account when analyzing a project, the expected net presant value (NPV) of the project will typically be than the true NPV of the project. 11 5 6 7 8 9 0

Explanation / Answer

Year Sale price Production Cost 1 $ 14,800.00 $             7,228.00 2 $ 14,948.00 $             7,300.28 3 $ 15,097.48 $             7,373.28 4 $ 15,248.45 $             7,447.02 Sale price in year 4 = 14800 x 1.01^(4-1) = 15,248.45 Cost of production in year 4 =7225 x 1.01^3 =7447.02 Inflation increases the price of the goods. This means true value of money decreases. Thus, if inflation is not taken into account, it means NPV is having inflation factor in it. This means the value is higher than the true NPV.

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