Recall that NPV can be interpreted as the change in the value of the firm at the

Question

Recall that NPV can be interpreted as the change in the value of the firm at the time the project is initiated (t-0). Assume future net benefits increase annually by 5%, the average expected inflation rate over the life of the project, and the nominal MARR is 10%. What is the lesson here? 3. a. Project nominal cash flows and calculate NPV using the nominal MARR. Year Cash Flow ($10,000) 2 0 $4,200 NPV = $ b. Project real cash flows and calculate NPV using the real MARR Year Cash Flow ($10,000)S4,000 0 123 Real MARR = NPV = $ c. What is the lesson (project evaluation best practice)?

Explanation / Answer

1.

Nominal Cash Flows

Year 0: -10000

Year 1: 4200

Year 2: 4200*1.05=4410

Year 3: 4410*1.05=4630.5

So, NPV=-10000+4200/1.1+4410/1.1^2+4630.5/1.1^3=941.77

2.

Real Cash Flows

Year 0: -10000

Year 1: 4200/1.05=4000

Year 2: 4410/1.05^2=4000

Year 3: 4630.5/1.05^3=4000

(1+Nominal MARR)=(1+inflation)*(1+real MARR)

hence, real MARR=1.1/1.05-1=4.7619%

So, NPV=-10000+4000/1.047619+4000/1.047619^2+4000/1.047619^3=941.77

The lesson is that the nominal cash flows should be evaluated suing nominal MARR and real using real MARR and both yield the same result

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