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The sum of the present values of the cash outflows for leasing and purchasing by borrowing shows that
purchasing is preferable because the PV of borrowing is less than the PV of leasing ($52,088 versus $53,763).The
incremental savings would be $1,675 ($53,763 $52,088).
8.11 CAPITAL BUDGETING AND INFLATION
The accuracy of capital budgeting decisions depends on the accuracy of the data regarding cash
inflows and outflows. For example, failure to incorporate pricelevel changes due to inflation in capital
budgeting situations can result in errors in the predicting of cash flows and thus in incorrect
decisions.
mically, an analyst has two options dealing with a capital budgeting situation with inflation: Either
restate the cash flows in nominal terms and discount them at a nominal cost of capital (minimum
required rate of return) or restate both the cash flows and cost of capital in constant terms and discount
the constant cash flows at a constant cost of capital. The two methods are basically equivalent.
EXAMPLE 8.22 A company has the following projected cash flows estimated in real terms:
Red Cash Flows (Ooos)
1 2 3
Period 0
35
100 50 30
The nominal cost of capital is 15percent. Assume that inflation is projected at 10 percent a year. Then the first cash
flow for year 1, which is $35,000 in current dollars, will be 35,000 X 1.10 = $38,500 in year 1dollars. Similarly the
cash flow for year 2 will be 50,000 X (1.10)2 = $60,500 in year 2 dollars, and so on. If we discount these nominal
cash flows at the 15 percent nominal cost of capital, we have the following net present value (NPV):
218 CAPITAL BUDGETING (INCLUDING LEASING) [CHAP. 8
PVIF
(Appendix C)
Period Cash Flows Present Values
100  100
1.ooo
0
38.5 0.870 33.50
1
60.5 0.756 45.74
2

26.25
39.9 0.658
3
or $5,490
NPV 5.49

=
˜˜˜
Instead of converting the cashflow forecasts into nominal terms, we could convert the cost of capital into real
terms by using the following formula:
1 + nominal cost of capital
1
Real cost of capital =
1 + inflation rate
In the example, this gives
Real cost of capital = (1 + 0.15)/(1 + 0.10)  1
= 1.1511.10 1
= 1.045  1
= 0.045 or 4.5%
We will obtain the same answer except for rounding errors ($5,490 versus $5,580).
1 PVIF = l/(l+ 0.045)''
Period Cash Flows Present Values
100
0 1.ooo 100
1/(1 + 0.045) = 0.957
1 35 33.50
2 1/(1.045)2 = 0.916 45.80
50

3 30 1/(1.045)3 = 0.876 26.28
NPV = 5.58 or $5,580
Review Questions
1. The initial investment is plus installation cost minus plus or
minus
.These breakdowns are subject
2. The total gain is split into and
to tax rates.
3. Aftertax cash inflows equal net profits after taxes plus
The NPV method and the IRR method are called
4. methods.
219
CAPITAL BUDGETING (INCLUDING LEASING)
CHAP. 81
decisions.
is the process of making
5.
divided by the cash inflow through increased revenues or
is the
6.
cash savings in operating expenses.
, the less risky the project and the greater the
7. The shorter the
8. Accounting rate of return does not recognize the
equals
9. Internal rate of return is the rate at which
10. Accept the investment if its IRR exceeds
11. IRR is difficult to compute when the cash flows are
, the NPV and the IRR methods may produce
12. In
is used widely in ranking the investments competing for limited funds.
13.
, thus implicitly
method discounts all cash flows at the
14. The
assuming that these cash flows can be reinvested at this rate.
15. MACRS rules abandon the concept of
16. is taken in the year in which an asset is first placed into service.
17. The straightline depreciation method with allows the company to deduct only
year.
half of the regular straightline deduction amount in the
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