Tversky and Co. have devised a new psychological test for investors' risk tolerance. They expect to sell 10,000 tests in the first year at $150 each. Cash costs associated with producing, administering and scoring the test are $50 per unit. In the second year, volume is expected to be the same, but both the price and the costs will increase 2.5%. Forecast gross profit in the second year.
Answer:
Revenue 10,000 units × $150 × 1.025 = $1,537,500
Cash Costs 10,000 units × $50 × 1.025 = 512,500
Gross Profit $1,025,000
When computing the NPV of a project, if cash flows are discounted at the real cost of capital, then the cash flows should not be adjusted for inflation.
Answer: TRUE
When computing the NPV of a project, it is important to consistently use either nominal dollars and nominal rates or real dollars and real rates.
Answer: TRUE
When computing project cash flows, it is necessary to apply the same rate of inflation to all costs and revenues.
Answer: FALSE
What is meant by "real dollars" and the "real" discount rate? How can they be used to account for inflation when evaluating capital budgeting proposals?
Answer: Real dollars are used to represent prices or expenses in the absence of inflation. If an item sells for $10 one year and $10.30 the following year solely because of inflation and not because of other factors such as supply and demand, the price would still be stated as $10 "real" dollars. When using real dollars, the interest rate is also disinflated. With 3% inflation, a 10% interest rate is disinflated to 10% - 3% = 7% or more precisely, (1.10/1.03) - 1 = 6.8%.
