A firm is considering a project costing $50,000. The estimated nominal net cash flows for the project are as follows. Year Net Cash Flows 1 $20,000 2 $30,000 3 $20,000 The real cost of capital is 10% p.a. The expected inflation rate is 5% p.a. for the first year which is expected to increase to 7% p.a. for the following two years.
a) Calculate the net present value of the project using: (i) the nominal cash flows and (ii) the real cash flows. Are these net present values the same given that the expected inflation rate changes after year 1? Explain.
b) Calculate the payback period of the project using the nominal net cash flows. Does the Payback period depend on whether the real or nominal cash flows are used to compute it?
c) How would you go about computing the internal rate of return of this project? That is, set up an equation that someone could use to compute the project's internal rate of return. Note that you do not need to compute the actual internal rate of return.