PAYBACK, NET PRESENT VALUE, INTERNAL RATE OF RETURN, INTANGIBLE BENEFITS, INFLATION ADJUSTMENT Foster Company wants to buy a numerically controlled (NC) machine to be used in producing specially machined parts for manufacturers of trenching machines (to replace an existing manual system). The outlay required is $3,500,000. The NC equipment will last five years with no expected salvage value. The expected incremental after-tax cash flows (cash flows of the NC equipment less cash flows of the old equipment) associated with the project follow:
Year Cash Benefits Cash Expenses 1 $3,900,000 $3,000,000 2 3,900,000 3,000,000 3 3,900,000 3,000,000 4 3,900,000 3,000,000 5 3,900,000 3,000,000 Foster has a cost of capital equal to 10 percent. The above cash flows are expressed without any consideration of inflation.
Required:
. Compute the payback period.
. Calculate the NPV and IRR of the proposed project.
. Inflation is expected to be 5 percent per year for the next five years. The discount rate of 10 percent is composed of two elements: the real rate and the inflationary element. Since the discount rate has an inflationary component, the projected cash flows should also be adjusted to account for inflation. Make this adjustment, and recalculate the NPV. Comment on the importance of adjusting cash flows for inflationary effects.
Problem