Question

One of your colleagues has given you constant dollar information about the anticipated savings cash flow from a modernization project that your team is evaluating. This project will last 3 years. Your colleague believes the savings at the end of the first year will be $30,000 and it will increase by $1000 each of the following years 2 and 3.

Your company requires economic evaluations be calculated using actual dollars for all cash flows. You know that the general inflation rate is 4% and the inflation-free interest rate is 6%.

What is the present worth of the savings cash flows using actual dollar analysis? (Assume annual compounding for the interest rate you use for the present worth calculation.)

Answer 1

Inflation rate = 4%

Inflation free interest rate = 6%

Discount rate = 4% + 6%

= 10%

Discount rate for cash flow is 10%.

Cash flow in year 1 is $30,000, cash flow in year 2 is $31,000 and cash flow in year 3 is $32,000.

Present value of cash flow = [$30,000 / (1 +10%)] + [$31,000 / (1 +10%) ^ 2] + [$32,000 / (1 +10%) ^ 3]

= ($30,000 / 1.10) + ($31,000 / 1.21) + ($32,000 / 1.331)

= $27,272,73 + $25,619,83 + $24,042.07

= $76,934.64

Present value of cash flow is $76,934.64.