Solution Finance Principle Chapter 6 Braeley Myers Allen

1. See the table below. We begin with the cash flows given in the text, Table 6.6, line 8, and utilize the following relationship from Chapter 3:

Real cash flow = nominal cash flow/(1 + inflation rate)t

Here, the nominal rate is 20 percent, the expected inflation rate is 10 percent, and the real rate is given by the following:

(1 + rnominal) = (1 + rreal)  (1 + inflation rate)

1.20 = (1 + rreal)  (1.10)

rreal = 0.0909 = 9.09%

As can be seen in the table, the NPV is unchanged (to within a rounding error).

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Net Cash Flows/Nominal -12,600 -1,484 2,947 6,323 10,534 9,985 5,757 3,269

Net Cash Flows/Real -12,600 -1,349 2,436 4,751 7,195 6,200 3,250 1,678

NPV of Real Cash Flows (at 9.09%) = $3,804

2. No, this is not the correct procedure. The opportunity cost of the land is its value in its best use, so Mr. North should consider the $45,000 value of the land as an outlay in his NPV analysis of the funeral home.

3. Unfortunately, there is no simple adjustment to the discount rate that will resolve the issue of taxes. Mathematically:

and

4. Even when capital budgeting calculations are done in real terms, an inflation forecast is still required because:

a. Some real flows depend on the inflation rate, e.g., real taxes and real proceeds from collection of receivables; and,

b. Real discount rates are often estimated by starting with nominal rates and “taking out” inflation, using the relationship:

(1 + rnominal) = (1 + rreal)  (1 + inflation rate)

5. Investment in working capital arises as a forecasting issue only because accrual accounting recognizes sales when made, not when cash is received (and costs when incurred, not when cash payment is made). If cash flow forecasts recognize the exact timing of the cash flows, then there is no need to also include investment in working capital.

6. If the $50,000 is expensed at the end of year 1, the value...