Concept explainers
The Rodriguez Company is considering an average-risk investment in a mineral water spring project that has an initial after-tax cost of $170,000. The project will produce 1,000 cases of mineral water per year indefinitely, starting at Year 1. The Year-1 sales price will be $138 per case, and the Year-1 cost per case will be $105. The firm is taxed at a rate of 25%. Both prices and costs are expected to rise after Year 1 at a rate of 6% per year due to inflation. The firm uses only equity, and it has a cost of capital of 15%. Assume that cash flows consist only of after-tax profits because the spring has an indefinite life and will not be
- a. What is the present value of future cash flows? (Hint: The project is a growing perpetuity, so you must use the constant growth formula to find its
NPV .) What is the NPV? - b. Suppose that the company had forgotten to include future inflation. What would they have incorrectly calculated as the project’s NPV?
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