Question

Pl be unique and mention every formula and details. You are interested in an investment project...

Pl be unique and mention every formula and details.

You are interested in an investment project that costs $44,625 initially. The investment has a 5-year horizon and promises future end-of-year cash inflows of $11,900, $12,495, $11,305, $8,925, and $8,330, respectively. Your current opportunity cost is 6.83% per year. However, the Fed has stated that inflation may rise by 1.5% or may fall by the same amount over the next 5 years.

Assume a direct positive impact of inflation on the prevailing rates (Fisher effect) and answer the following questions: (Assume that inflation has an impact on the opportunity cost, but that cash flows are contractually fixed and are not affected by inflation.)

a) What is the net present value (NPV) of the investment under the current required rate of return?

b) What is the net present value (NPV) of the investment under a period of rising inflation?

c) What is the net present value (NPV) of the investment under a period of falling inflation?

d) From your answers in (a), (b), and (c), what relationship do you see emerge between changes in inflation and asset valuation?

Homework Answers

Answer #1

working note -1 G2=1/1.683

d4 = first option at the end of first year

0.0683 =1/1
years option -1 at current inflation rate option-2 at increase in infaltion rate option-3 derease in infaltion rate
1 =1/1.683 =+D4*1.015 =+E4*1.015
2 =+D4*$G$2 =+D5*1.015 =+E5*1.015
3 =+D5*$G$2 =+D6*1.015 =+E6*1.015
4 =+D6*$G$2 =+D7*1.015 =+E7*1.015
5 =+D7*$G$2 =+D8*1.015 =+E8*1.015
after above calculation the resultant figures are as folllows
6.83% 1
years option -1 at current inflation rate option-2 at increase in infaltion rate option-3 derease in infaltion rate
1 0.594177065 0.6030897 0.6121361
2 0.353046384 0.3583421 0.3637172
3 0.209772064 0.2129186 0.2161124
4 0.124641749 0.1265114 0.128409
5 0.074059269 0.0751702 0.0762977
after attaining table value we need to calculate discounted cash inflows asa follows
solution for a solution for b solution for c
option-1 option-2 option-3
initial out flow A -44625 -44625 -44625
cash inflows cash inflows(1) discount rate (2) Discounted inflows(1*2) cash inflows(3) discount rate (4) Discounted inflows(3*4) cash inflows(5) discount rate (6) Discounted inflows(5*6
year 1 11900 0.594177065 7070.707 11900 0.603089721 7176.77 11900 0.612136067 7284.42
year2 12495 0.353046384 4411.315 12495 0.35834208 4477.48 12495 0.363717211 4544.65
year 3 11305 0.209772064 2371.473 11305 0.212918645 2407.05 11305 0.216112425 2443.15
year 4 8925 0.124641749 1112.428 8925 0.126511376 1129.11 8925 0.128409046 1146.05
year 5 8330 0.074059269 616.9137 8330 0.075170158 626.167 8330 0.07629771 635.56
B 15582.84 15816.6 16053.8
NPV A+B -29042.2 -28808 -28571
d. therefore from above cal culations we could see increase in inflation rate leads to lesser inflows and lead to lesser NPV and vice versa
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