8. The cash flow distribution assoclated with a five-year project is shown below

Question

8. The cash flow distribution assoclated with a five-year project is shown below. Time (years) 0 Cash flow (S) 10,000 4,000 5,000 5,500 6,100 Assuming that the cash flows are given in that year's $ and that a general monetary inflation rate of 5% applies throughout the project's life, determine the net present value using a minimal acceptable rate of return of 12%. [$10,403] Assuming that the cash flows are given in that year's $ and that a general monetary inflation rate of 6.25% applies throughout the project's life, determine the net present value using a minimal acceptable rate of return of 12%. [S11.165] a. b. Answers in Bold

Explanation / Answer

8. Real interest rate formula:

When the rate of inflation is 5%

1 + i = (1 + r)(1 + )

1 + 0.12 = (1+r)(1.05)

1+r = 1.12/1.05 = 1.066

Real interest rate (r) = 1.066 – 1 = 0.066 or 6.6%

• a. The net present value should be calculated with this real interest rate

Net present value = -$10,000 + 4,000/1.066 + 4,400/(1.066)^2 + 5,000/(1.066)^3 + 5,500/(1.066)^4 + 6,100/(1.066)^5

Net present value = -$10,000 + 3,752.34 + 3,872.02 + 4,127.6 + 4,259.25 + 4,431.42

Net present value = $-10,000 + 20442.63 = $10,442.63.

b. When inflation rate is 6.25%

1 + r = 1.12/1.0625 = 1.054

Real interest rate (r) = 1.054 – 1 = 0.054 or 5.4%

Net present value = = -$10,000 + 4,000/1.054 + 4,400/(1.054)^2 + 5,000/(1.054)^3 + 5,500/(1.054)^4 + 6,100/(1.054)^5

Net present value = -$10,000 + 3,795.06 + 3,963.96 + 4,273.5 + 4,471.54 + 4,692.3

Net present value = -$10,000 – 21,196.36 = $11,196.36.

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