(11–8)

Inflation Adjustments The Rodriguez Company is considering an average-risk investment in a mineral water spring project that has a cost of $150,000. The project will produce 1,000 cases of mineral water per year indefinitely. The current sales price is $138 per case, and the current cost per case is $105. The firm is taxed at a rate of 34%. Both prices and costs are expected to rise at a rate of 6% per year. The firm uses only equity, and it has a cost of capital of 15%. Assume that cash flows consist only of after-tax profits, since the spring has an indefinite life and will not be depreciated.

a. Should the firm accept the project? (Hint: The project is a perpetuity, so you must use the formula for a perpetuity to find its NPV.)

b. Suppose that total costs consisted of a fixed cost of $10,000 per year plus variable costs of $95 per unit, and suppose that only the variable costs were expected to increase with inflation. Would this make the project better or worse? Continue to assume that the sales price will rise with inflation.