Question:
INFLATION AND CAPITAL BUDGETING
Leo Thayn, manager of the Electronics Manufacturing Division, has been pushing headquarters to grant approval for the installation of a new computer-aided design system.
Finally, in the last executive meeting, Leo was told that if he could show the new system would increase the firm's value, then it would be approved. Leo has collected the following information:
|
|
Old System
|
CAD System
|
|
Initial investment
|
-
|
$1,250,000
|
|
Annual operating costs
|
$300,000
|
$95,000
|
|
Annual depreciation
|
$100,000
|
MACRS
|
|
Effective tax rate
|
34%
|
34%
|
|
Cost of capital
|
12%
|
12%
|
|
Expected life
|
10 years
|
10 years
|
|
Salvage value
|
none
|
none
|
With the exception of the cost of capital, the preceding information ignores the rate of inflation, which has been 4 percent per year and is expected to continue at this level for the next decade.
Required:
1. Compute the NPV for each system.
2. Compute the NPV for each system, adjusting the future cash flows for the rate of inflation.
3. Comment on the importance of adjusting cash flows for inflationary effects.