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Payback, Net Present Value, Internal Rate of Return, Intangible Benefits, Inflation Adjustment For discount factors use Exhibit 12B-1 and Exhibit 12B-2. Foster Company wants to
Payback, Net Present Value, Internal Rate of Return, Intangible Benefits, Inflation Adjustment For discount factors use Exhibit 12B-1 and Exhibit 12B-2. 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 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 1 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. Required: 1. Compute the payback period. Round your answer to two decimal places. 3.89 years 2. Calculate the NPV and IRR of the proposed project. Use the minus sign to indicate a negative NPV. Round IRR to the nearest percent. NPV -88,370 x IRR 9 % 3. CONCEPTUAL CONNECTION: 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. Round present value calculations and your final answer to the nearest dollar. $ 422,217 x Comment on the importance of adjusting cash flows for inflationary effects. Since the required rate of return for capital budgeting analysis reflects an inflationary component at the time NPV analysis is performed, a correct analysis also requires that the predicted operating cash flows be adjusted to reflect inflationary effects. If the operating cash flows are not adjusted, then an erroneous decision may be the outcome. Notice, for example, that after adjusting for inflation, the new system is now favored-a totally different decision
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