3. Inflation in project analysis

It is often easy to overlook the impact of inflation on the net present value of the project. Not incorporating the impact of inflation in determining the value of the cash flows of the project can result in erroneous estimations.

Consider the following scenario:

Houston and Smith Corp. is considering opening a new division to produce units that it expects to sell at a price of $14,800 each in the first year of the project. The company expects the cost of producing each unit to be $7,225 in the first year; however, it expects the selling price and cost per unit to increase by 3% each year.

Based on the preceding information, the company expects the selling price in the fourth year of the project to be _________, and it expects the cost per unit in the fourth year of the project to be_______ .

Which of the following statements about inflations effect on net present value (NPV) is correct?

a. When the selling price and cost per unit are expected to increase at the same rate, forgetting to take inflation into account in a capital budgeting analysis will typically cause the estimated NPV to be lower than the true NPV.

b. When the selling price and cost per unit are expected to increase at the same rate, you do not need to take inflation into account when performing a capital budgeting analysis.