Sensitivity to Inflation M. Holden is considering whether to invest $200,000 in a new computer that will last five years, have $20,000 scrap value, and generate cash savings in clerical costs of $60,000 annually, using today’s prices and payroll rates. It is December 31, 19_0.

The minimum desired rate of return is 22 percent per year before taxes.

All analysis will be conducted on a before-tax basis.

. Compute the net present value of the project.

2. Holden is concerned about how to allow for inflation, which has persisted at a 10 percent average annual rate during the past five years. He decides that the 22 percent rate embodies an element attributable to anticipated inflation.

Consequently, to make the decision model consistent, the cash savings and scrap value should be adjusted upward in accordance with the 10 percent inflation rate. That is, there will be 10 percent inflation in year one. Using these assumptions, repeat requirement 1.

. Compare your answers in requirements 1 and 2. What generalizations about the effects of inflation seem warranted?

(For more on inflation, see Problem 13-16.)  L01