Xi Phan, CEO of the Furniture Supply Group, is considering an investment to upgrade his current computer-aided design equipment. The new equipment would cost $110 000, have a five-year useful life and a zero terminal cash flow value. The new equipment would generate annual cash operating savings of $36 000. The entity’s required rate of return is 18 per cent each year.

Required

(a) Calculate the NPV of the project. Assume a 25 per cent marginal tax rate and straight-line depreciation, ignoring the half-year convention.

(b) Phan is wondering whether the method in part (a) provides a correct analysis of the effects of inflation. The 18 per cent required rate of return incorporates an element attributable to anticipated inflation. For purposes of his analysis, Phan assumes that the existing rate of inflation, 5 per cent annually, will persist over the next five years. Recalculate the NPV, adjusting the cash flows as appropriate for the 5 per cent inflation rate.

(c) Compare the quantitative results for parts (a) and (b). In general, how does inflation affect capital budgeting quantitative results?

(d) Explain why managers cannot predict future inflation rates with total accuracy.

(e) In your own words, explain how failure to consider the effects of inflation might bias managers’ capital budgeting decisions.