Question

Impact of inflation on investments Personal Finance Problem You are interested in an investment project that costs $44, 250 initially. The investment has a 5-year horizon and promises future end-of-year cash inflows of $11,800, $12,390, $11,210, $8,850, and $8,260, respectively. Your current opportunity cost is 6.28% 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 effect) and answer the following questions: (Assume that inflation has an impact on the opportunity cost, but that cash flows are contractually fixed and are not affected by inflation.) a. What is the net present value (NPV) of the investment under the current required rate of return? b. What is the net present value (NPV) of the investment under a period of rising inflation? c. What is the net present value (NPV) of the investment 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 valuation? a. The net present value of the investment under the current required rate of return is $ (Round to the nearest cent.) b. The net present value of the investment under a period of rising inflation is $ . (Round to the nearest cent.) c. The net present value of the investment under a period of falling inflation is $ (Round to the nearest cent.) d. From your answers in (a), (b), and (c), what relationship do you see emerge between changes in inflation and asset valuation? (Select from the drop-down menu.) As the inflation rate rises the NPV of a given set of cash flows

Answer 1

a]

NPV is calculated using NPV function in Excel.

NPV is $187.64.

fc =NPV(6.28%,B3:B7)+B2 D E F C B8 - A B 1 Year Cash Flow 0 ($44,250) 1 $11,800 $12,390 3 $11,210 4 $8,850 5 $8,260 8 NPV $187.64

b]

With inflation, opportunity cost = (1 + opportunity cost without inflation) * (1 + inflation).

opportunity cost = (1 + 6.28%) * (1 + 1.5%) = 7.87%.

NPV is -$1,539.79.

fx =NPV(7.87%,B3:37)+B2 D E C FF B8 А B Cash Flow 0 ($44,250) 1 $11,800 2 $12,390 3 $11,210 4 $8,850 5 $8,260 8 NPV ($1,539.79)

c]

With inflation, opportunity cost = (1 + opportunity cost without inflation) * (1 + inflation).

opportunity cost = (1 + 6.28%) * (1 + (-1.5%)) = 4.69%.

NPV is $2,031.87.

B8 fx =NPV(4.69%,B3:B7)+B2 D E F A C 0 1 2 3 4 5 Cash Flow ($44,250) $11,800 $12,390 $11,210 $8,850 $8,260 $2,031.87 8 NPV

d]

As the inflation rate rises, the NPV of a given set of cash flows decreases.