You are interested in an investment project that costs $40,000 initially. The in

Question

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?

Explanation / Answer

Formula for calculation of NPV = Present value cash inflows- Present value of cash outflows.

Answer for question no.a is $5,008.51 ----Refer note below

Answer for question no.b is $3,357.14 ---Refer note below

Answer for question no.c is $6,764.87.-----------Refer note below

Answer for question d is when inflation increases then investment value decreases and when inflation decreases then investment value increases.

Note:

Oppurtunity cost when inflation is rising, it means nominal interest rate = real interest rate +inflation

Here opportunity cost is considered as real interest rate.

Therefore if inflation is raising by 1.5%,

=6.5% +1.5%

=8%

When inflation is falling the nominal rate = 6.5% - 1.5%

=5%

Rise in inflation Fall in inflation Year Cash outflow Cash inflows Discount factor @6.5% Discounted cash flows Discount factor @8% Discounted cash flows Discount factor @5% Discounted cash flows 0 -$40,000.00 1 -$40,000.00 1 -$40,000.00 1 -$40,000.00 1 $12,000.00 0.93896714 $11,267.61 0.925925926 $11,111.11 0.952380952 $11,428.57 2 $12,500.00 0.88165928 $11,020.74 0.85733882 $10,716.74 0.907029478 $11,337.87 3 $11,500.00 0.82784909 $9,520.26 0.793832241 $9,129.07 0.863837599 $9,934.13 4 $9,000.00 0.77732309 $6,995.91 0.735029853 $6,615.27 0.822702475 $7,404.32 5 $8,500.00 0.72988084 $6,203.99 0.680583197 $5,784.96 0.783526166 $6,659.97 NPV $5,008.51 $3,357.14 $6,764.87

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