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NPV - over or under estimated

Assume that a less developed country called LDC encourages direct foreign investment (DFI) in order to reduce its unemployment rate, currently at 15 percent. Also assume that several MNCs are likely to consider DFI in this country. The inflation rate in recent years has averaged 4 percent. The hourly wage in LDC for manufacturing work is the equivalent of about $5 per hour. When Piedmont Co. develops cash flow forecasts to perform a capital budgeting analysis for a project in LDC, it assumes a wage rate of $5 in Year 1 and applies a 4 percent increase for each of the next 10 years. The components produced are to be exported to Piedmont's headquarters in the United States, where they will be used in the production of computers. Do you think Piedmont will overestimate or underestimate the net present value of this project? Why? (Assume that LDC's currency is tied to the dollar and will remain that way).

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The NPV will be overestimated. The reason is that Piedmont is assuming the increase in wage rate only account of inflation. The wage rate may ...

Solution Summary

The solution explains how to determine if the NPV is over or under estimated for the given situation