The following information is available about an investment opportunity. Investment will occur at year 0 and sales

Question:

The following information is available about an investment opportunity. Investment will occur at year 0 and sales will occur from year 1 to year 8. Use a nominal discount rate, calculated as i_n = (1 + i_r)(1 + p) – 1, where ir is the real discount rate, and p is expected inflation.

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%
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 net present value assuming zero inflation.

c. How do the internal rate of return and net present value change when you assume an inflation rate of 8 percent per year in price and variable cost per unit?

d. How do you explain the fact that inflation causes the internal rate of return to increase and the NPV to decrease?

e. Does inflation make this investment more attractive or less attractive? Why?

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