Question

Edward Laren, an accountant with Tenergy Industries, prepared the following analysis of an investment in manufacturing equipment:
Cost savings:
Labor savings .................. $500.000
Reduction in rework materials.............. 125,000
Other........................ 60,000
Total...................... 685,000
Additional taxes related to cost savings.......... (239,750)
Tax savings related to depreciation of new equipment... 161,000
Annual cash flow................... $ 606,250
Present value at 10 percent for five years......... 2,298,173
Cost of equipment.................. 2,300,000
Net present value.................. ($ 1,827)

Edward’s boss, Megan Mangione, reviewed the calculation and made the following bservation:”Ed, you’ve assumed that there won’t be inflation, but inflation is built into our 10 percent cost of capital. I think it’s reasonable to assume that labor and costs other than depreciation will increase by 4 percent per year. Why don’t you redo the analysis with that assumption?”

Required
a. What does Megan Mangione mean by “inflation to our 10 percent costs of capital”?
b. Redo Edward Larne’s analysis assuming an inflation rate of 4 percent. Should the company make the investment in the equipment?



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  • CreatedSeptember 23, 2013
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