Inflation AdjustmentsThe Rodriguez Company is considering an average-risk investment in amineral water spring project that has a cost of $150,000. The project willproduce 1,000 cases of mineral water per year indefinitely. The current salesprice is $138 per case, and the current cost per case is $105. The firm istaxed at a rate of 34%. Both prices and costs are expected to rise at a rate of6% per year. The firm uses only equity, and it has a cost of capital of 15%.Assume that cash flows consist only of after-tax profits, because the springhas an indefinite life and will not be depreciated.a. Should the firm accept the project? (Hint: The project is a growing perpetuity, so you must use the constant growth formula to find its NPV.)b. Suppose that total costs consisted of a fixed cost of $10,000 per yearplus variable costs of $95 per unit, and only the variable costs wereexpected to increase with inflation. Would this make the project betteror worse? Continue to assume that the sales price will rise with inflation.
Inflation Adjustments
The Rodriguez Company is considering an average-risk investment in a
mineral water spring project that has a cost of $150,000. The project will
produce 1,000 cases of mineral water per year indefinitely. The current sales
price is $138 per case, and the current cost per case is $105. The firm is
taxed at a rate of 34%. Both prices and costs are expected to rise at a rate of
6% per year. The firm uses only equity, and it has a cost of capital of 15%.
Assume that
has an indefinite life and will not be depreciated.
a. Should the firm accept the project? (Hint: The project is a growing perpetuity, so you must use the constant growth formula to find its NPV.)
b. Suppose that total costs consisted of a fixed cost of $10,000 per year
plus variable costs of $95 per unit, and only the variable costs were
expected to increase with inflation. Would this make the project better
or worse? Continue to assume that the sales price will rise with inflation.
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