Net Present Value and Inflation Edward Laren, an accountant with Tenergy Industries, prepared the following analysis of an investment in manufacturing equipment.

Edward's boss, Megan Mangione, reviewed the calculation and made the following observation: "Ed, you've assumed that there won't be inflation, but inflation is built into our 10 -percent cost of capital. I think it's reasonable to assume that labor and costs other than depreciation will increase by four percent per year. Why don't you redo the analysis with that assumption."
Required
a. What does Megan Mangione mean by "inflation is built into our 10 percent cost of capital"?
b. Redo Edward Laren's analysis assuming an inflation rate of 4 percent. Should the company make the investment in the equipment?

Transcribed Image Text:

Cost savings: Labor savings Reduction in rework materials Other Total Additional taxes related to cost savings Tax savings related to depreciation of new equipment Annual cash flow Present value at 10 percent for five years Cost of equipment Net present value $ 425,000.00 100,000.00 50,000.00 575,000.00 (201,250.00) 140,000.00 $ 513,750.00 $1,947,523.50 2,000,000.00 (52,476.50)