Question

Inflation Adjustments

The Rodriguez Company is considering an average-risk investment in a mineral water spring project that has a cost of $160,000. The project will produce 900 cases of mineral water per year indefinitely. The current sales price is $140 per case, and the current cost per case is $106. The firm is taxed at a rate of 38%. Both prices and costs are expected to rise at a rate of 5% per year. The firm uses only equity, and it has a cost of capital of 12%. Assume that cash flows consist only of after-tax profits, because the spring has an indefinite life and will not be depreciated.

1. What is the NPV of the project? Do not round intermediate steps. Round your answer to the nearest hundred dollars. (Hint: The project is a growing perpetuity, so you must use the constant growth formula to find its NPV.)

Answer 1

NPV of the project = present value of cash inflows - initial investment

present value of cash inflows = cash inflow in 1st year / (cost of capital - growth rate)

cash inflow in 1st year = (sale price - cost per case) * number of cases * (1 - tax rate)

cash inflow in 1st year = ($140 - $106) * 900 * (1 - 38%) = $18,972

present value of cash inflows = $18,972 / (12% - 5%)

present value of cash inflows = $271,028.57

NPV of the project = present value of cash inflows - initial investment

NPV of the project = $271,028.57 - $160,000 = $111,028.57