You are interested in an investment project that

 

costs $40,000 initially. The investment has a 5-year horizon and promises future endof-

year cash inflows of $12,000, $12,500, $11,500, $9,000, and $8,500, respectively.

Your current opportunity cost is 6.5% per year. However, the Fed has stated that inflation

may rise by 1.5% or may fall by the same amount over the next 5 years.

Assume a direct positive impact of inflation on the prevailing rates (Fisher effect) and

answer the following questions. (Assume that inflation has an impact on the opportunity

cost, but that the cash flows are contractually fixed and are not affected by inflation).

a. What is the net present value (NPV) of the investment under the current required

rate of return?

b. What is the net present value (NPV) of the investment under a period of rising

inflation?

c. What is the net present value (NPV) of the investment under a period of falling

inflation?

d. From your answers in a, b, and c, what relationship do you see emerge between

changes in inflation and asset valuation?