The following information is available about an investment opportunity. Investment will occur at time 0 and sales will commence at time 1.
Initial cost | $28 million |
Unit sales | 400,000 |
Selling price per unit, this year | $60.00 |
Variable cost per unit, this year | $42.00 |
Life expectancy | 8 years |
Salvage value | $0 |
Depreciation | Straight-line |
Tax rate | 37% |
Nominal discount rate | 10.0% |
Real discount rate | 10.0% |
Inflation rate | 0.0% |
a. Prepare a spreadsheet to estimate the project’s annual after-tax cash flows.
b. Calculate the investment’s internal rate of return and its NPV.
c. How do your answers to questions (a) and (b) change when you assume a uniform inflation rate of 8 percent a year over the next 10 years? (Use the following equation to calculate the nominal discount rate: in= (1 + ir)(1 + p) – 1, where in is the nominal discount rate, ir is the real discount rate, and p is expected inflation.)
d. How do you explain the fact that inflation causes the internal rate of return to increase and the net present value to decrease?
e. Does inflation make this investment more attractive or less attractive? Why?
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