Question

AW Adjusted for Inflation: consider the following scenario;

▪ Spend $1,000,000 now for 3-year IT service contract

▪ Expect 4% return over cost of capital of 8.5%

▪ Inflation averages 6% per year

• What annual amount is needed to recover cost ?

Answer 1

Solution :

In given problem expected return is 4% over 8.5% of capital cost i.e. $85000

Inflation = 6% per year

Time = 3 year

Annual amount needed to recover cost (Annual Worth) = AW1 + AW2

where,

AW1 = Annual returrn for $85000 (for which 4% return is expected or 10% return with inflation of 6% adjustment is expected.)

AW2 = Annual returrn for $915000 (for which no return is expected or 6% return with inflation of 6% adjustment is expected.)

Thus, Annual Worth = 85000(A/P,10%,3) + 915000(A/P,6%,3)

Annual Worth = $ 34179 + $342310 = $376490

Thus, Annual amount needed to recover cost is $376490 per year.

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