574 CHAPTER II Inflation and Its Impact on Project Cash initial investment will

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574 CHAPTER II Inflation and Its Impact on Project Cash initial investment will be depr that the initial in Assume tt the five-year MACRS and that Sonie (a) Determine the project cash flows in actual ated u tax rate will be 30%. Son a rate of at least 10% in other investment during this inflation-ridden period. )Determine the project cash flows in acti (time-0) dollars. the cash flows associated with e the projected after-tax rate of (c) Is this project acceptable? Rate of Return Analysis under Inflation(a) Determi 11.26 Miami Machine Shops, Ltd. is purchasing a vertical drill machine. The machine will cost $62,000 and will have an eight-year serv life. The selling price of the machine at the end eight years is expected to be $5,000 in today's dol lars. The machine will generate annual revenue of $22,000 (today's dollars), but the company e to have an annual (e of $9,500 (today's dollars). The asset is classi fieti as l investment over its life. (real or inflation-free) for this investn tunity and jstify whether or not it is (b) Comput Ppor of undertaking. ve $10,000 cash that you wa 28-Su xpectsto invest. Normally, you would deposit the mon expense (excluding depreciation) a savings account that pays an annual interest RS property. The project requires |sibility of investing in a bond. Your alternative of 6%. However, you are now considering the MACRS either a nontaxable municipal bond paying 9% or taxable corporate bond paying 12%. Your marginal tax rate is 30% for both ordinary income and capi tal gains. You expect the general inflation to be 3% during the investment period. You can buy 0 pital investment of $10,00 at ye The marginal income tax rate for the firm is ave ing 35%. The firm's market interest rate is 18% (a) Determine the internal rate of return of his investment. ation grade municipal bond costing $10,000 that pa ini ial (b) Assume that the firm expects a pays Interest of 9% ($900) per year. This interest isnt t that it also expects'un 8% wor rate of king capital and xable. A comparable high-grade corporate bond n al ncrease)n xpense autolbynf a- also available that is just as safe as the municipal nd, but it pays an interest rate of 12% ($1.200 r year. This interest is taxable as ordinary income. infflation-free) internal 1.27 Sonja Jensen is considering the purchase of lot that is to be converted into a parking lot in six per month. The franchise and necessary equipmernt te of return. Is this project acceptable? oth bonds mature at the end of year 5 a fast-food franchise. Sonja will be operating on a a) Determine the real (inflation-free) rate of retun he interim for $800 b) Without knowing your MARR, can you make a lvage Airline is considering two types of engine for each bond. years, but that may be rented in t choice between these two bonds? will have a total initial cost of $55,000 and a salva value of $1 0,000 (in today's dollars) after six years. for use in its planes. Each engine has the same d that the future annual general inflation the same maintenance, and the same repai will be 5%. The projected operating revenues and expenses (in actual dollars) other than rent and Engine A costs $100,000 depreciation for the business are: of fuel per 1,000 hours of operation att and uses 50,000 g service load encountered in passenger service. .Engine B costs $200,.000 and uses 32,000 gallom End of Year RevenuesEx of fuel per 1,000 hours of operation erv Both engines are estimated to have 10.0o required. If fuel currently costs $5.90 per-,of 8% install for an expected 2,000 hours of hours before any major overhaul of the its price is expected to increase at the because of inflation, which engine should

Explanation / Answer

Real rate =( (1+nominal rate)/(1+inflation))-1 ie. (1.1/1.05)-1 4.76% Real rate to use as discount rate (to discount cash flows) Real rate calculations Year 0 1 2 3 4 5 6 Initial investment -55000 Salvage 10000 Revenues at real rates 35000 38000 55000 60000 70000 60000 Less: expenses 16000 21000 23000 32000 33000 33000 Less: Rent (800*12) 9600 9600 9600 9600 9600 9600 MACRS depn. 11000 17600 10560 6336 6336 3168 EBT -1600 -10200 11840 12064 21064 14232 Tax at 30% 0 0 3552 3619 6319 4270 EAT -1600 -10200 15392 15683 27383 18502 Add back: Depn. 11000 17600 10560 6336 6336 3168 a. Operating cash flow 9400 7400 25952 22019 33719 21670 Annual cash flows -45000 9400 7400 25952 22019 33719 21670 PV F at 4.76% 1 0.95456 0.91119 0.86979 0.83027 0.79254 0.75653 PV at 4.76% -45000 8973 6743 22573 18282 26724 16394 NPV at inflation-free rate 54688 After-tax rate of return = 54688/45000= 121.53% The project can be undertaken as it gives positive NPV Nominal rate calculations Year Actual Operating cash flow Nominal Cash flow PV F at 10% PV at 10% 0 -45000 -45000 1 -45000 1 9400 9400*1.05^1= 9870 0.90909 8973 2 7400 7400*1.05^2= 8158.5 0.82645 6743 3 25952 25952*1.05^3= 30042.68 0.75131 22572 4 22019 22019*1.05^4= 26764.23 0.68301 18280 5 33719 33719*1.05^5= 43034.94 0.62092 26721 6 21670 21670*1.05^6= 29039.87 0.56447 16392 NPV at nominal rate(Unadjusted for inflation) 54681 Negligible difference in NPV is due to the rounding- off of real discount rate.

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