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Hello sir.I have a question about inflation. This Question is from Kaplan Revision book.
Spotty Ltd plans to purchase a machine costing $18,000 to save labour costs through efficiency savings. Labour savings would be $9,000 in the first year and would increase in the second year by 10%. The estimated general annual rate of inflation is 8% and the company’s real cost of capital is estimated at 12%. The machine has a two?year life with an estimated actual salvage value of £5,000 receivable at the end of year 2. All cash flows occur at the year?end. What is the negative NPV (to the nearest $10) of the proposed investment?
In this question, I just want to know here. The question says that the labor saving for the 1st year is 9000. This means that the figure given for the 1st year is an inflated figure. Therefore, we do not need to inflate it again. But the figure of 9000 for the 2nd year It is said that it will increase by 10%. I think that after increasing the figure of 9000 by 10% in the 2nd year, we should additionally inflate it, because the inflation was done only for the 1st year, not for the 2nd year. In addition, we have to do 1-year inflation for the figure in the 2nd year.
So 9000*110%*(1+0.08)^1=10692
But in the answer to the question, the labor cost figure for the second year is 9900. That is, inflation was not taken into account for the second year.
I don’t know where I am going wrong, Could you please explain me the part I am doing wrong? Thanks in advance
If it is 9,000 at the end of the first year and inflates by 10%, then at the end of the second year it will be 9,900. The general rate of inflation is irrelevant for the labour savings because you are told the specific rate of inflation that applies to it.
Have you watched my free lectures on investment appraisal with inflation?
Thank you for your reply.
But here I think that 10% increase is meant as an increase, not as an inflation number. For example, how can we say that our sales will increase by 10% every year, after increasing our sales by 10%, we add inflation accordingly. Why can’t we use that form here?This is nothing to do with sales. It says that the labour saving will increase by 10%, which is the same as saying that it inflates by 10%.
8% is the overall rate of inflation but that does not mean that every item with inflate at 8%. Som items will inflate at a higher rate and some will inflate at a lower rate.
Have you watched my lectures?
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