Deck 11: Inflation and Its Impact on Project Cash Flows

Question 1

An iron casting company has received an order to supply 300 units of casted fireplace inserts each year for
Midwestern Builders over a 2-year period. The current sales price is $1,500 per unit, and the current cost per
unit is $1,000. The firm is taxed at a rate of 30%. Both prices and costs are expected to rise at a rate of 6% per
year. The firm will produce these units on fully-depreciated existing machines. Since the orders will be filled at
the end of each year, the unit sale price and unit cost during the first year would be $1,590 and $1,060,
respectively. The firm's market interest rate is 15%. Compute the net present worth of this project.

Answer 1

Question 2

You are considering purchasing a $1,000 bond with a coupon rate of 9.5%, interest payable annually. If the
current inflation rate is 4% per year, which will continue in the foreseeable future, what would be the real rate
of return if you sold the bond at $1,080 after 2 years?

Answer 2

Question 3

Suppose a business is considering purchasing $40,000 machine that will result in increased sales of $30,000 per
year but also increased operating costs of $10,000; additional profits will be taxed at a rate of 50%. Depreciation
is assumed to be taken on a straight-line basis over four years with no expected salvage value. What will
happen to this project's rate of return if inflation during the next four years is expected to be 10% annually?

Answer 3

Question 4

The current gasoline price is $3.15, and this price represents a 5% increase over a year ago, an 8% increase over
two years ago, and a 3% decrease over three years ago. What is the average inflation rate for the last 3 years?

Question 5

Which of the following statements is incorrect under inflationary economy?
(a) Borrowers will always come out ahead as they pay back with cheaper dollars.
(b) In general, you will pay more taxes in real dollars if you have depreciable assets.
(c) In general, there will be more drain in working capital.
(d) Bond interest rates will tend to be higher in the financial market, so that it would cost more to finance a new
Project.

Question 6

If the inflation rate is 6% per year and the market interest rate is known to be 15% per year. What is the implied
real interest rate in this inflationary economy?

Question 7

Which of the following statements is correct under an inflationary economy?
(a) Generally you will pay less tax in real dollars if you have depreciable assets.
(b) Debt financing is always a preferred option because you are paying back with cheaper dollars.
(c) Government will collect less tax in short-run, but end up collecting more in the long-run.
(d) Actual dollar analysis is always preferred whereas the effects of income taxes must be considered.

Question 8

You are considering purchasing a corporate bond, which matures on December 31, 2015 (5-year bond) at a
market price of $1030. It has a par value of $1,000, a 7% coupon rate, and interests will be paid annually.
Suppose you will hold the bond until its maturity. If you expect a 4% general inflation rate annually during this
holding period, what would be your real (true) yield to maturity (rate of return)?

Question 9

A $40,000 investment in working capital is expected to generate $7,200 additional yearly cash flow after tax. All
of the working capital will be recovered at the end of the project's four-year life. What will happen to the rate of
return of this investment project if inflation during the next four years is expected to be 10% annually?

Question 10

Which of the following statements is most correct? (a) As inflation increases, the real rate of return on capital investments tends to decrease if all other conditions
Remain unchanged.
(b) The real income tax rate increases with the rate of inflation and the age of the asset.
(c) As we experience a higher inflation, we will expect the real rate of return on working capital investments to
Decrease.
(d) All of the above