You are interest in an investment project that costs $7,500 initially. The investment has a 5-year horizon and promises future end-of-year cash inflows of $2,000, $2,000, $2,000 $1,500 and $1,500, respectively. Your current opportunity cost is 6.5% per year. However, the Fed has stated that inflation may rise by 1% or may fall by the same amount.

Assume a direct positive impact of inflation on the prevailing rates (Fisher effect) and answer the following questions.

a. What is the net present value (NPV) of the investment under the current required rate of return?
b. What is the net present value (NPV) of the investment under a period of rising inflation?
c. What is the net present value (NPV) of the investment under a period of falling inflation?
d. From your answer a, b,and c, what relationship do you see emerge between changes in inflation and asset valuation?

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Solution
Opportunity cost if inflation rises by 1%=6.5%+1%=7.50%
Opportunity cost if inflation falls by 1%=6.5%-1%=5.50%

Let us calculate NPV in each case.

Year End Cash Flow PV @ 5.5% PV @ 6.5% PV @ 7.5%
n Cn =Cn/(1+5.5%) =Cn/(1+6.5%) =Cn/(1+7.5%)
0 -7500 ...

Solution Summary

Solution analyzes the impact of inflation on net present value of an investment.

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