Question

QUESTION 3 (10

Pelosi Company is considering a project with the following information.

The initial investment of the project costs the company $15,000 now (outflow at t₀). The real interest rate (r) is 15% and the expect inflation rate (h) is 10%. All cash flows in Year 1 and Year 2 occur at the end of the year.

Year	Nominal Cash Flow	Real Cash Flow
1	$11,000	real CF1 = ?
2	$24,200	real CF2 = ?

1. Using Fisher equation, what is the nominal interest rate (R)?

    (Note: You are required to use the exact equation and not to use the approximation method.)

2. marks)

2. What are the real cash flows in Year 1 and in Year 2 (that is, find real CF1 and real CF2)?
   2. marks)

(c) Use nominal cash flows and nominal interest rate to find the net present value (NPV) of the project.

3. marks)

(d) Use real cash flows and real interest rate to find the net present value (NPV) of the project?

Answer 1

a)

nominal interest rate= [(1+real interest rate)*(1+inflation rate) - 1]

=(1+0.15)*(1+0.1)-1

=26.5%

b)nominal cash flow includes inflation

real cash flow= nominal cash flows/( 1+inflation rate)ⁿ

year one = 11000/1.10=10000

year two= 24200/(1.10) =24200/1.21 =20000

c)npv of nominal cash flow

d)npv of real cash flows