Sylvester Media is analyzing an average-risk project, and the following data hav

Question

Sylvester Media is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made vs. if it is not made? Project cost of capital (r) 10.0% Net investment cost (depreciable basis) $200,000 Units sold 50,000 Average price per unit, Year 1 $25.00 Fixed op. cost excl. deprec. (constant) $150,000 Variable op. cost/unit, Year 1 $20.20 Annual depreciation rate 33.333% Expected inflation 4.00% Tax rate 35.0% a. $13,286 b. $14,721 c. $16,230 d. $13,985 e. $15,457

Explanation / Answer

available information - project life = 3 years, Depriciation is on straight line basis, salvage value = 0

unit sales will be constant and sales price per unit will rise with inflation

project cost of capital = 10%, inflation rate = 4%

calculation of NPV with inflation factor -

Calculation of NPV without inflation factor -

Now the difference between them = 260695.9 - 245974.9

= 14721

so the correct option should be (b) $14721.

please note all values are in $,

In case of any clarification required please comment.

Year 0 1 2 3 NPV Initial investment 200000 Unit sold per year 50000 50000 50000 average price per unit 25 26 27.04 sales value 1250000 1300000 1352000 variable cost per unit 20.2 21.01 21.85 less Total variable cost 1010000 1050400 1092416 less Depriciation 66660 66660 66680 EBIT 173340 182940 192904 less tax @ 35% 60669 64029 67516.4 EAT 112671 118911 125387.6 add Depriciation 66660 66660 66680 Cash flow -200000 179331 185571 192067.6 Discounting @ 10% 1 0.909091 0.826446 0.751315 PV @ 10% -200000 163028.2 153364.5 144303.2 260695.9

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