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Problem: 11-49 NPV inflation

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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

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