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Problem: 11-49 NPV inflation

Inflation and Capital Budgeting

Problem: 11-49

The head of the corporate tax division of a major public relations firm has proposed investing $295,000 in personal computers for the staff. The useful life and recovery period for the computers are both 5 years. The firm uses MARC's depreciation. There is no terminal salvage value. Labor savings of $125,000 per year (in year-zero dollars) are expected from the purchase. The income tax rate is 45%, and the after tax required rate of return is 20%, which includes a 4% element attributable to inflation.

1. Compute the NPV of the computers. Use the nominal required rate of return and adjust the cash flow for inflation.(for example; year 1 cash flow = 1.04 X year 0 cash flow)
2. Compute the NPV of the computers using the nominal required rate of return without adjusting the cash flows for inflation
3. Compare your answers in number 1 and 2. Which is correct? Would using the incorrect analysis generally lead to overinvestment or underinvestment? Explain


Solution Summary

Your tutorial is in Excel, attached. Click in cells to see computations.