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​, Your current opportunity cost is 6.50% 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.   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 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?

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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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​,
Your current opportunity cost is 6.50% 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.
 
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 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?
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