Please answer completely and correctly all questions thanks Fall 2017 ourse Mate
ID: 2786522 • Letter: P
Question
Please answer completely and correctly all questions thanks
Fall 2017 ourse Matea apital Budgeting: Estimating Cash Flows and Analyzing Risk aded Assignment Due Thursday 11.23.17 at 09 Attempts: Keep the Highest: (3 7. Inflation in project analysis it is often easy to overlook the impact of infation on the net present value of the project. Not incorporating the impact of inflation in determining the value of the cash flows of the project can result in erroneous estimations Consider the following scenario: Galaxy Corp. is considering opening a new division to produce units that it expects to sell at a price of $12,450 each in the first year of the project. The company expects the cost of producing each unit to be $6,700 in the first year; however, it expects the selling price and cost per unit to increase by 3% each year. Based on the preceding information, the company expects the selling price in the fourth year of the project to be and it expects the cost per unit in the fourth year of the project to be Which of the following statements about inflation's effect on net present value (NPV) is correct? O When the selling price and cost per unit are expected to increase at the same rate, forgetting to take inflation into account in a capital budgeting analysis will typically cause the estimated NPV to be lower than the true NPV O when the selling price and cost per unit are expected to increase at the same rate, you do not need to take nflation into account when performing a capital budgeting analysis.Explanation / Answer
Selling price in the fourth year would be the future value of $12450 compounded each yeat with a growth factor of 3% per year for next four years.
Selling price in fourth year = Today's Selling price * (1+r)^n
Here the Present Value is the todays selling price of $12450
Growth rate (r) = 3%
n (number of years) here would be 3, because it has asked for the selling price in the fourth year, so the growth factor would be compounded only three times
Selling price at the end of four years = 12450*(1+3%)^3 = 12450 * 1.03^3 = 12450 * 1.092727 = $13,604.45 (Answer)
Since the cost is also expected to grow at the rate of 3% per year after first year. It will have the same formula to calculate.
Cost in the first year is $6700
n = 3 yrs
r = 3%
Cost in fourth year = 6700* (1+3%)^3 = 6700*1.092727 = $7321.27 (Answer)
Inflation effect on NPV:
The first option is correct. forgetting to take inflation into consideration will make the NPV lowet than the actual NPV.
In our above example see the sales revenue has gone up by 13604.45-12450 = 1154
But the cost has gone above by only 7321-6700 = 621.
If the company doesnt take Inflation into account, then the NPV would be lower than the real NPV. Just as the above case, the growth in selling price is greater in fourth year than the first year, because the value of sales price is greater than the cost of the product. Thus it increases at a greater margin even if the growth rate of 3% remains same for both cost and sales price. Thus not taking inflation into account would make the sales price projection greater than the ost price projection, and cause a lower NPV.