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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 $12,000 when general inflation is 0% 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?
A. The NPV would remain the same
B. The NPV would rise
C. The NPV would fall
D. The NPV could rise or fallMy Tutor has stated the answer as B explaining that the cash flows within the year will rise but if they are subject to inflation wouldn’t the cost of capital be inflated (money rate of return) therefore the NPV shouldn’t change.
I am surprised that you did not ask your tutor this 🙂
He/she is wrong and the answer is C.
The reason is that although the cash revenue inflows will increase and the money cost of capital would also increase, and so the PV of these would not change, the problem is the sales proceeds from the sale of the asset.
The question says that the sale proceeds are not subject to inflation, and therefore the cash receipt would stay the same. However the money cost of capital will still be higher, and therefore the PV of the sale proceeds would be lower and therefore the NPV would be lower.I hope you are watching my free lectures on this. The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
Wow, they probably made a mistake.
I did not think of it like that such a simple solution, ugh I should have known.
Yes, I do watch your free lectures even twice sometimes, they are unbelievably helpful.
Thank you!!
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