You are considering a new project, which is expected to have the following nomin

Question

You are considering a new project, which is expected to have the following nominal cash flows of $35000, $36000, $38000, $40000, $42000 in years 1 through 5. The company’s nominal cost of capital is 12%. The expected inflation rate is 2.5%. (A) Estimate the company’s real cost of capital. (B) Estimate the real cash flows on this project. (C) Estimate the total present value, based on real cash flows and the real discount rate. (D) What is the maximum amount you are willing to invest in this project?

Explanation / Answer

(A) Estimate the company’s real cost of capital.

Company’s real cost of capital = (1+Nominal rate)/(1+inflation rate) - 1

Company’s real cost of capital = (1+12%)/(1+2.5%) -1

Company’s real cost of capital = 9.26829%

(B) Estimate the real cash flows on this project.

Real cash flows on this project :

Year 1= 35000/1.025 = $ 34,146.34

Year 2 = 36000/1.025^2= $ 34,265.32

Year 3 =  38000/1.025^3= $ 35,286.78

Year 4 =  40000/1.025^4= $ 36,238.03

Year 5 =  42000/1.025^5= $ 37,121.88

(C) Estimate the total present value, based on real cash flows and the real discount rate.

Total present value =34146.34/1.0926829+34265.32/1.0926829^2+35286.78/1.0926829^3 +36238.03/1.0926829^4+37121.88/1.0926829^5

Total present value = $ 136,249.29

(D) What is the maximum amount you are willing to invest in this project?

Maximum amount you are willing to invest in this project =  $ 136,249.29

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