Sylvester Media is analyzing an average-risk project, and the following data hav

Question

Sylvester Media is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made vs. if it is not made?

10.0%

$200,000

50,000

$25.00

$150,000

$20.20

33.333%

4.00%

35.0%

WACC

10.0%

Net investment cost (depreciable basis)

$200,000

Units sold

50,000

Average price per unit, Year 1

$25.00

Fixed op. cost excl. deprec. (constant)

$150,000

Variable op. cost/unit, Year 1

$20.20

Annual depreciation rate

33.333%

Expected inflation

4.00%

Tax rate

35.0%

Explanation / Answer

Year - 1 Year - 2 Year - 3 Net Investment 200000 200000 200000 Sales (50000*25) 1250000 1250000 1300000 1352000 Less: Variable Cost (50000*20.2) 1010000 1010000 1050400 1092416 Less: Fixed Operating Costs 150000 150000 150000 Less: Depreciation 66666.66667 66666.66667 66666.66667 Net Income 23333.33333 32933.33333 42917.33333 Less: Tax 8166.666667 11526.66667 15021.06667 Net Income After Tax 15166.66667 21406.66667 27896.26667 Add: Depreciation (200000*33.33%) 66666.66667 66666.66667 66666.66667 Net Cash Inflows 81833.33333 88073.33333 94562.93333 WACC 0.909090909 0.826446281 0.751314801 WACC 10% PV Year 1 81833.33333 0.909090909 $74,393.94 Year 2 88073.33333 0.826446281 $72,787.88 Year 3 94562.93333 0.751314801 $71,046.53 PV of Cash Inflows $218,228.35 Less: Investment 200000 Net Present Value $18,228.35 Net Investment 200000 200000 200000 Sales (50000*25) 1250000 1250000 1250000 1250000 Less: Variable Cost (50000*20.2) 1010000 1010000 1010000 1010000 Less: Fixed Operating Costs 150000 150000 150000 Less: Depreciation 66666.66667 66666.66667 66666.66667 Net Income 23333.33333 23333.33333 23333.33333 Less: Tax 8166.666667 8166.666667 8166.666667 Net Income After Tax 15166.66667 15166.66667 15166.66667 Add: Depreciation (200000*33.33%) 66666.66667 66666.66667 66666.66667 Net Cash Inflows 81833.33333 81833.33333 81833.33333 WACC 0.909090909 0.826446281 0.751314801 WACC 10% PV Year 1 81833.33333 0.909090909 $74,393.94 Year 2 81833.33333 0.826446281 $67,630.85 Year 3 81833.33333 0.751314801 $61,482.59 PV of Cash Inflows $203,507.39 Less: Investment 200000 Net Present Value $3,507.39 $14,720.96

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