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Problem - 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 depreciated.
Required -
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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