Question

Impact of inflation on investments The Choc Shop is considering buying new equipment
with an initial investment outlay of $32,000. The equipment has a 5-year life
with cash inflows in years 1 to 5 of $11,500, $12,000, $12,500, $10,000, and $9,500, respectively. You earn 6% on all your current investments. The economists,
however, have forecasted that inflation may rise by 1% or may fall by 1% over the
next 5 years. Inflation will only influence the opportunity cost since the cash inflows
are fixed.
a. Calculate the net present value (NPV) of the investment under the current required
rate of return.
b. Calculate the net present value (NPV) of the investment under a period of rising
inflation.
c. Calculate the net present value (NPV) of the investment under a period of falling
inflation.
d. Based on your answers in parts a, b, and c, describe the relationship between
changes in inflation and asset valuation.

Answer 1

Ans a)
		year	cost	PVIF @6%	present worth
		0	$ (32,000.00)	1.0000	$ (32,000.00)
		1	$    11,500.00	0.9434	$    10,849.06
		2	$    12,000.00	0.8900	$    10,679.96
		3	$    12,500.00	0.8396	$    10,495.24
		4	$    10,000.00	0.7921	$      7,920.94
		5	$      9,500.00	0.7473	$      7,098.95
		total			$    15,044.14
		NPV =			$    15,044.14
Ans b)	With raising inflation rate required rate = 6%+1% =7%
		year	cost	PVIF @7%	present worth
		0	$ (32,000.00)	1.0000	$ (32,000.00)
		1	$    11,500.00	0.9346	$    10,747.66
		2	$    12,000.00	0.8734	$    10,481.26
		3	$    12,500.00	0.8163	$    10,203.72
		4	$    10,000.00	0.7629	$      7,628.95
		5	$      9,500.00	0.7130	$      6,773.37
		total			$    13,834.97
		NPV =			$    13,834.97
Ans c)	With falling inflation rate required rate = 6%-1% =5%
		year	cost	PVIF @55	present worth
		0	$ (32,000.00)	1.0000	$ (32,000.00)
		1	$    11,500.00	0.9524	$    10,952.38
		2	$    12,000.00	0.9070	$    10,884.35
		3	$    12,500.00	0.8638	$    10,797.97
		4	$    10,000.00	0.8227	$      8,227.02
		5	$      9,500.00	0.7835	$      7,443.50
		total			$    16,305.23
		NPV =			$    16,305.23
Ans d)
	There is inverse ralationship between inflation and net present value
	With incresae in inflation expected or required rate will increase and present value of cash flow will reduce
	with falling in inflation expected or required rate will decrease and present value of cash flow will increase