FIN 486 Expect Success/uophelp.com FIN 486 Expect Success/uophelp.com | Page 31

P12–6
Impact of inflation on investments You are interested in an
investment project that costs $40,000 initially. The investment has a
5-year horizon and promises future end-of-year cash inflows of
$12,000, $12,500, $11,500, $9,000, and $8,500, respectively. Your
current opportunity cost is 6.5% per year. However, the Fed has stated
that inflation may rise by 1.5% or may fall by the same amount over
the next 5 years.
LG 2
Assume a direct positive impact of inflation on the prevailing rates
(Fisher effect) and answer the following questions. (Assume that
inflation has an impact on the opportunity cost, but that the cash flows
are contractually fixed and are not affected by inflation).
a.What is the net present value (NPV) of the investment under the
current required rate of return?
b.What is the net present value (NPV) of the investment under a
period of rising inflation?
c.What is the net present value (NPV) of the investment under a
period of falling inflation?
d.From your answers in a, b, and c, what relationship do you see
emerge between changes in inflation and asset valuation?
P12–17
Real options and the strategic NPV Jenny Rene, the CFO of Asor
Products, Inc., has just completed an evaluation of a proposed capital
expenditure for equipment that would expand the firm’s
manufacturing capacity. Using the traditional NPV methodology, she
found the project unacceptable because
LG 6
NPVtraditional = −$1,700 < $0
Before recommending rejection of the proposed project, she has
decided to assess whether there might be real options embedded in the
firm’s cash flows. Her evaluation uncovered three options:
Option 1: Abandonment. The project could be abandoned at the end
of 3 years, resulting in an addition to NPV of $1,200.