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This is purely an investment appraisal question. However there is one statement that i dont understand what to do about.
It says”The new technology is expected to reduce operating costs by $5·80 per unit in current price terms. This reduction in operating costs is before taking account of expected inflation of 5% per year.”
In the solution they have directly inflated the figure for relevant years.
But i dont understand why? It says the OC is “reduced” by $5.8 per unit in current terms. So if there was an inflation, the price that was charged per unit would be certainly more in the respective years… So that would make the reduction lesser than the direct inflation…
Not sure if iv been able to put my doubt properly… 🙁
Thanks in Advance
If a flow is given in current prices and is subject to inflation, then it will increase year by year.
It does not matter whether it is a cost, or revenue, or (as here) a saving.
And it is logical. The total operating costs (even though they are not relevant here) will inflate, and therefore so will the saving.
Suppose currently the operating costs are 100, and the new technology saves 5. So with the new technology that costs would be 95.
Suppose there is inflation at 10%.
Next year, without the technology the costs would be 110. With the technology the costs would be 95 x 1.1 = 104.5
So next year the saving is 110 – 104.5 = 5.5
This is a 10% higher saving than the saving at current prices.
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