Inflation and not-for-profit institution, no tax aspects. Eastern University is considering the purchase of a photocopying machine for $4,200 on December 31, 2007. It has a useful life of five years, has a zero terminal disposal price, and is amortized on a straight-line basis. The cash operating savings are expected to be $1,200 annually, measured in December 31, 2007, dollars. The discount factor is 18.8%, which includes the effects of anticipated inflation of 10%. The university pays no taxes. The present values of $1 discounted at 18.8% received at the end of 1, 2, 3, 4, and 5 periods are 0.842, 0.709, 0.596, 0.502, and 0.423.

Required 1. A university official computed the net present value of the project using an 18.8% discount rate without adjusting the cash operating savings for inflation. What net present value figure did he compute? Is this approach correct? If not, how would you redo the analysis?

2.

(a) What is the real rate of return required by Eastern University for investing in the photocopying machine?

(b) Calculate the net present value using the real rate of return approach to incorporating inflation.

3. Compare your analyses in requirements 1 and 2. Present generalizations that seem applicable about the analysis of inflation in capital budgeting.