Question

Impact of inflation on investments   Personal Finance Problem  You are interested in an investment project that costs $43,500 initially. The investment has a 5​-year horizon and promises future​ end-of-year cash inflows of $11,600​, $12,180​, $11,020​, $8,700​, and $8,120​, respectively. Your current opportunity cost is 6.93 % 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?

Answer 1

a. Calculation of Net present value at discounted rate 6.93%. Discount rate @6.93% = Present Value = Cash Year Cashflows (1/1.0693)^n flows *Disc. Rate 11,600 0.935191247 10,848.22 2 12,180 0.874582668 10,652.42 11,020 0.817902055 9,013.28 4 8,700 0.764894843 6,654.59 8,120 0.715322961 5,808.42 Total Present Value Cashflows 42,976.92 Less : Initial Investment (43,500.00) Net Present Value (NPV) (523.08) b. If the inflation raises 1.5% then the discounted rate of return = 6.93% +1.5% = 8.43% Discount rate @8.43%= Year Cashflows (1/1.0843)^n 11,600 0.922253989 12,180 0.850552420 11,020 0.784425362 8,700 0.723439419 8,120 0.667194890 Total Present Value Cashflows Less : Initial Investment Net Present Value (NPV) Present Value = Cash flows * Disc. Rate 10,698.15 10,359.73 8,644.37 6,293.92 5,417.62 41,413.79 (43,500.00) (2,086.21)

C. If the inflation falls 1.5% then the discounted rate of return will be 6.93% - 1.5% = 5.43% Discount rate @5.43%= Year Cashflows (1/1.0543)^n 11,600 0.948496633 12,180 0.899645863 11,020 0.853311071 8,700 0.809362678 8,120 0.767677775 Total Present Value Cashflows Less : Initial Investment Net Present Value (NPV) Present Value = Cash flows *Disc. Rate 11,002.56 10,957.69 9,403.49 7,041.46 6,233.54 44,638.73 (43,500.00) 1,138.73 5 D. By looking into the above clauations Inflation directly impact the Net Present value of the Project. If the inflation Increases, NPV is decreasing and vice versa.