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Sir, why don’t we use nominal rate of 15.5% directly as the discount rate in here?
A company is considering investment in new labour-saving equipment costing $1m. The current wage rate is $5 per hour but this is expected to increase by 5% each year into the foreseeable future. The equipment is expected to save 20,000 labour hours per year.
The company’s nominal cost of capital is 15.5%.
What is the present value of the savings in wage costs over a 10-year planning period (to the nearest $000)?
A.$385,000
B.$558,000
C.$615,000
D.$676,000You can do it either way and still get 615,000 or approximately
1. Calculate Real Discount Rate or
2. Inflate Cash Flows First ….So I don’t really understand your question because you can do it either way
Use the Fisher Equation to strip the specific wage inflation to get the 15.5% to 10%
Then
10% annuity factor for 10 years 6.145 to the real baseline saving $100,000 times 6.145=$614,500100,000 * 1.05 = $105,000
$105,000\ 1.155 = $90,909
Repeating this for all 10 years and summing the values yields the exact same total of $614,457 (rounded to $615,000).
Ah, I understand now. The gap was on my side. I saw that real figures had been used in the answer, so I thought there might be something different that I wasn’t seeing. Thank you very much for taking the time to answer 🙂
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