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- April 23, 2018 at 4:28 pm #448565
question:
A project has an initial outflow at time 0, when an asset is bought, then a series of revenue inflows at the end of each year, and then finally sales proceeds from the sale of the asset.
Its NPV is 12000 pound when general inflation is zero % per year.If general inflation were to rise to 7% per year, and all revenue inflows were subject to this rate of inflation but the initial expenditure and resale value of the asset were not subject to inflation, what would happen to the NPV?
The answer is ” The NPV would fall”
the explanation of the answer sheet below
1. The NPV impact of the initial outflow is unaffected ( YES i agree Sir)
2. The revenue flows will be subject to inflation, but then should be discounted at a money rate which includes this inflation. The net effect is no change in the PV( Money rate is probably Nominal rate based on your lecture Sir. i am convinced that due to inflation rate, the inflow would increase. i have no idea why there is no effect)
(1+N)=(1+R)(1+I)…. so based on this, as the rise in the inflation rate, the Nominal rate will rise as well, therefore inflows should be increased but it is said “no effect”
why???
3. The sales proceeds represent a flow of money, not affected by inflation, but this will now be discounted at a higher money rate, lowering the net present value of the project.
(i don’t understand due to the same reason as (2) ).Have good night Sir.
April 23, 2018 at 6:47 pm #448586If you watch my free lectures, you will see that with higher rates of inflation then so too the nominal cost of capital will be higher. For the inflating flows, the net effect of discounting the nominal flows at the nominal cost of capital will make no difference to the NPV. However, for non-inflating flows, the higher cost of capital will mean that the NPV is reduced.
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