With extra cash from operations, Ace Auto Parts decides to buy a Savings and loa

Question

With extra cash from operations, Ace Auto Parts decides to buy a Savings and loan. Ace will pay 400,000 for the S & L with the intention of selling it after five years. Ace hopes to earn a 20% before - tax rate of return. The expected inflation rate is 5%.

A) What should be the amount of the sale price, if Ace is to earn a 20% return on their investment? Exclude the effects of inflation.

B) What should be the amount of the sale price, if Ace is to earn a 20% return on their investment after considering the effects of inflation?

Explanation / Answer

A)

PV or initial investment = $400,000

Selling price of FV = ?

rate of return, r = 20% (with ourt considering the effect of inflation)

time, n = 5 years

FV = PV*(1+r)^n

FV = 400,000*1.2^5 = $995328 (ANSWER)

ACE should sell it at a price of $995328 to earn 20% return

B)

if ACe has to earn 20% return after considering inflation, it means,

real return = 20%

nominal return = real return+ inflation (approximated formula)

(1+nominal return) = (1+real return)*(1+ inflation) (exact formula)

if we consider approximated formula,

nominal return = 20+5 = 25%

ACE has to earn 25% return in nominal term

FV = PV*(1+r)^n

FV = 400,000*1.25^5 = $1220703.125 (ANSWER, if consider approximate formula )

if we consider exact formula

(1+nominal) = 1.2*1.05 = 1.26

nominal rate = .26 = 26%

ACE has to earn 26% return in nominal term

FV = PV*(1+r)^n

FV = 400,000*1.26^5 = $1270318.775 (ANSWER, if consider exact formula )

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