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Expected NPV if Inflation Adjustment is Made

Dumpe Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price will increase with inflation. Fixed costs will also be constant, but variable costs will rise with inflation. The project should last for 3 years, and there will be no salvage value. This is just one project for the firm, so any losses can be used to offset gains on other firm projects. The marketing manager does not think it is necessary to adjust for inflation, but the CFO thinks an adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made vs. if it is not made?

WACC 10.0%
Net investment cost (depreciable basis) $100,000
Units sold 40,000
Average price per unit, Year 1 $25.00
Fixed op. cost excl. depr'n (constant) $150,000
Variable op. cost/unit, Year 1 $20.25
Annual depreciation rate 33.333%
Expected inflation 5.00%
Tax rate 40.0%

a. $12,174
b. $12,815
c. $13,490
d. $14,164
e. $14,872

Solution Preview

Please see the attached file. The difference in NPV is 13,490

Depreciaton 33,333.33 33,333.33 33,333.33
Income before tax 6,666.67 6,666.67 6,666.67
Tax 2,666.67 2,666.67 2,666.67
Net Income 4,000.00 4,000.00 4,000.00
Operating Cash ...

Solution Summary

The solution explains the change in NPV if inflation adjustment is made as compared to if the inflation adjustment is not made. Excel spreadsheet of calculations included.