Study Appendix 11. Enrique Mendoza, the president of a Mexican wholesale company, is considering whether to invest 420,000 pesos in new semiautomatic loading equipment that will last 5 years, have zero scrap value, and generate cash operating savings in labor usage of 150,000 pesos annually, using 20X0 prices and wage rates. It is December 31, 20X0.
The required rate of return is 18% per year.
1. Compute the NPV of the project. Use 150,000 pesos as the savings for each of the 5 years.
Assume a 40% tax rate and, for simplicity, assume ordinary straight-line depreciation of 420,000 pesos, 5 = 84,000 pesos annually for tax purposes.
2. Mendoza is wondering if the model in number 1 provides a correct analysis of the effects of inflation. He maintains that the 18% rate embodies an element attributable to anticipated inflation. For purposes of this analysis, he assumes that the existing rate of inflation, 10% annually, will persist over the next 5 years. Repeat number 1, adjusting the cash operating savings upward by using the 10% inflation rate.
3. Which analysis, the one in number 1 or 2, is correct? Why?