Foster Company wants to buy a numerically controlled (NC) machine to be used in producing specially machined parts for the manufacturers of trenching machines (to replace an existing manual system). The outlay required is $3,500,000. The NC equipment will last 5 years with no expected salvage value. The expected incremental after-tax cash flows (cash flows of the NC equipment minus 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%. The above cash flows are expressed without any consideration of inflation.

1: Compute the payback period.

2: Calculate the NPV and IRR of the proposed project.

3: Inflation is expected to be 5% per year for the next 5 years. The discount rate of 10% 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.