Question

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1. You are a financial analyst at Gen-Eric Corporation, and you are considering two mutually exclusive projects. Unfortunately, the figures for project 1 are in nominal terms and the figures for project 2 are in real terms. The nominal discount rate for both projects is 8%, and the inflation rate is projected to be 4%. Which project should you choose?

(4 pts)

	Project 1	Project 2
0	-$50,000	-$40,000
1	40,000	30,000
2	50,000	40,000
3	70,000	75,000

Answer 1

- Project 1 figures are in Nominal Terms and its the discount rate is also in nominal terms. Thus, using both to calculate the NPV of the Project.

Year	Cash Flows of project 1 ($)	PV Factor @8.00%	Present Value of Project 1 ($)
0	(50,000.00)	1.0000	(50,000.00)
1	40,000.00	0.9259	37,037.04
2	50,000.00	0.8573	42,866.94
3	70,000.00	0.7938	55,568.26
		NPV	85,472.23

NPV of the Project 1 is $ 85,472.23

- Project 2 cash flows are in real terms which means that they are not inflation adjusted. Thus, first we will add inflation to the real terms cash flows to convert them into Nominal cash flow terms.

& then we will calculate the NPV of the project using nominal interest rate as discount rate to compute NPV of the Project:-

Year	Real Term cash flows	Inflation adjustment	Nominal terms Cash flows	PV Factor @8.00%	Present Value of Project 1 ($)
0	(40,000.00)	-	-40000	1.0000	(40,000.00)
1	30,000.00	30,000*(1+4%)^1	31200	0.9259	28,888.89
2	40,000.00	40,000*(1+4%)^2	43264	0.8573	37,091.91
3	75,000.00	75,000*(1+4%)^3	84364.8	0.7938	66,971.50
				NPV	92,952.29

Note- Cashflow in 0 period is not adjusted to inflation as its value is already in today's terms which is infalation adjusted while the future cash flows are not adjusted with increase in per year inflation value of money.

NPV of the Project 2 is $92,952.29

Hence, project 2 should be chosen

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