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Capital budgeting: Pro forma income with 10% inflation, expected NPV of project

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1. Pittsburg Corporation has sales of $100,000 a year and the sale price will increase with inflation. Inventory valuation is such that the effective cost of goods sold is the purchase price three months prior to sale. Depreciation is fixed, and other operating costs increase proportionately with inflation. The company sells on terms of net 30 and buys inventory on terms of net 60. All other purchases are for cash. Shown below is a financial statement for the first year of operation, with no inflation. Show the income for the following year with a 10% inflation rate.

Sales $100,000
Cost of goods sold 80
Depreciation 5,000
Other operating expenses 10,000
Earnings before tax 5,000
Tax 1,700
Net income $3,300

2. An investment costs $5,000, after tax considerations, and will generate cash flows of $1,000 a year over its life. The capital investment will last for 8, 9, or 10 years, with probabilities of 0.4, 0.4, and 0.2 respectively. At a 10% required return, compute the expected net present value and standard deviation of net present value.

3. Your firm and a possible project have the following cash flows:

Company Project
Economy good bad good bad
Year 0 -200 -200 -50 -50
Year 1 100 50 20 60
Year 2 120 60 30 50
Year 3 110 55 40 90
Year 4 90 45 35 70

Given 8% discount rate, a 60% chance of a good economy over the next 4 years, and a 40% chance of bad economy, what are the expected net present value and standard deviation of net present value for the company, for the project, for the combination of the company and the project?

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