Poulsen Industries is analyzing an average-risk project, and the following data

Question

Poulsen Industries 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. No change in net operating working capital would be required. This is just one of many projects for the firm, so any losses on this project 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 inflation adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made versus if it is not made?

WACC 10.0%

Net investment cost (depreciable basis) $200,000

Units sold 50,000

Average price per unit, Year 1 $25.00

Fixed oper. costs excl. depreciation (constant) $150,000

Variable oper. cost/unit, Year 1 $20.20

Annual depreciation rate 33.333%

Expected inflation 4.00%

Tax rate 40.0%

Explanation / Answer

With Inflation-NPV

With out Inflation-NPV

Difference in NPV=57,185

Particulars Year 1 Year 2 Year 3 Sales 12,50,000 13,00,000 13,52,000 Less: Variable cost 10,10,000 10,50,400 10,92,416 Contibution 2,40,000 2,49,600 2,59,584 Less: Fixed Cost 1,50,000 1,50,000 1,50,000 Depreciation 66,667 66,667 66,667 Profit Before tax 23,333 32,933 42,917 Less:tax 9,333 13,173 17,167 Profit after tax 14,000 19,760 25,750 Add: Depreciation 66,667 66,667 66,667 Cash Flows 80,667 86,427 92,417 PV Factor 0.9091 0.8264 0.7513 Present value of Cash flows 73,333 71,427 69,434 Total Present value of Cash flows for 3 years 2,14,194 Less:Intial Investment 2,00,000 NPV 14,194

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