Cy Keener, president of the Carbondale Architectural Design Group, is considering an investment to upgrade his current computer-aided design equipment. The new equipment would cost $110,000, have a five-year useful life, and have a zero terminal value. The new equipment would generate annual cash operating savings of $36,000. The company’s required rate of return is 18% per year.

Required:

A. Compute the net present value of the project. Assume a 25% marginal tax rate and straight-line depreciation, ignoring the half-year convention.

B. Keener is wondering whether the method in Part A provides a correct analysis of the effects of inflation. The 18% required rate of return incorporates an element attributable to anticipated inflation. For purposes of his analysis, Keener assumes that the existing rate of inflation, 5% annually, will persist over the next five years. Recalculate the NPV, adjusting the cash flows, as appropriate, for the 5% inflation rate.

C. Compare the quantitative results for Parts A and B. In general, how does inflation affect capital budgeting quantitative results?

D. Explain why managers cannot predict future inflation rates with total accuracy.

E. In your own words, explain how failure to consider the effects of inflation might bias managers’ capital budgeting decisions.