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Unformatted text preview: 126 a. Sales = 1,000($138)
Cost = 1,000($105)
Net before tax
Taxes (34%)
Net after tax $138,000
105,000
$ 33,000
11,220
$ 21,780 Not considering inflation, NPV is $4,800. This value is calculated as
$150,000 + $21,780
= $4,800.
0.15 Considering inflation, the real cost of capital is calculated as follows:
(1 + rr)(1 + i) = 1.15
(1 + rr)(1.06) = 1.15
rr = 0.0849.
Thus, the NPV considering inflation is calculated as
$150,000 + $21,780
= $106,537.
0.0849 After adjusting for expected inflation, we see that the project has a positive NPV and
should be accepted. This demonstrates the bias that inflation can induce into the
capital budgeting process: Inflation is already reflected in the denominator (the cost
of capital), so it must also be reflected in the numerator.
b. If part of the costs were fixed, and hence did not rise with inflation, then sales
revenues would rise faster than total costs. However, when the plant wears out and
must be replaced, inflation will cause the replacement cost to jump, necessitating a
sharp output price increase to cover the now higher depreciation charges.
127 E(NPV) = 0.05($70) + 0.20($25) + 0.50($12) + 0.20($20) + 0.05($30)
= $3.5 + $5.0 + $6.0 + $4.0 + $1.5
= $3.0 million.
σNPV= [0.05($70  $3)2 + 0.20($25  $3)2 + 0.50($12  $3)2
+ 0.20($20  $3)2 + 0.05($30  $3)2]0.5
= $23.622 million.
CV = $23.622
= 7.874.
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This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.
 Spring '08
 Staff

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