Question 11 Your boss asked you to evaluate a project with an infinite life. Sal

Question

Question 11 Your boss asked you to evaluate a project with an infinite life. Sales and costs project to $1,000 and $500 per year, respectively. (Assume sales and costs occur at the end of the year [i.e. profit of $500 at the end of year one]). There is no depreciation and the tax rate is 30 percent. The real required rate of return is 10 percent. The inflation rate is 4 percent and is expected to be 4 percent forever Sales and costs will increase at the rate of inflation. If the project costs $3,000, what is the NPV? $500.00 V B. $1,629.62 C. $365.38 D. $472.22 E. I choose not to answer Sales s cos $500 ( ax, 30%

Explanation / Answer

Annual CashFlow = $500

Annual Cashflow (after tax) = 500 x (1- Tax) = 500 * (1 - 0.30) = $ 350

Required Real Rate of Return = 10%

A real rate of return is the annual percentage return required after adjustment for inflation.

Therefore, Required Rate of Return (Nominal Return Required) = Real Rate of Return + Inflation = 10% + 4% = 14%

Growth Rate = 4%

Using Gordon's growth model, Present Value of Inflow = D1 / (ke-g) = 350 / (14%-10%) = $3,500

Present Value of Outflow = $3,000

Therfore NPV = 3500-3000 =$500

Option A is correct.

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