## M7A1 Problems and Solutions

In our discussion activity, we learned how inflation impacts tax analysis and world economies. In the

next set of comprehensive problems, you will apply what you learned. You may reference videos,

articles, and the like to help you process the problems.

After reading Chapters 14 and 15, review the additional supplemental videos, articles, and PowerPoint

presentation to help prepare you for working through these problems.

Using Excel, work through the following problems:

Problems

From Chapter 14 Meaning and Effect

A man bought a 5% tax-free municipal bond. It cost a $1000 and will pay $50 interest each for 20 years.

At maturity the bond returns the original $1000. If there is 2% annual inflation, what real rate of return

will the investor receive? Meaning and Effect

An investor wants a real rate of return of i* of 10% per year. If the expected annual inflation rate for the

next several years is 6%, what interest rate i should be used in project analysis calculations? Meaning and Effect

The average of a certain car was $18,000 ten years ago. This year the average cost is $30,000.

(a) Calculate the average monthly inflation rate (f m) for this model.

(b) Given the monthly rate, fm, what is the effective annual rate, f, of inflation for this model?

(c) Estimate what these will sell for 10 years from now, expressed in today’s dollars?

From Chapter 15 Cost of Funds

A small engineering firm has borrowed $125,000 at 8%. The partners have invested another $75,000. If

the partners require another 12% rate of return, what is the firm’s cost of capital:

(a) Before taxes?

(b) After taxes with a tax rate of 30%? Inflation

(a) What is the interest rate on a 2-year certificate of deposit at a bank or credit union in your area? (b) What is the recent value of the Consumer Price Index (CPI)?

(c) If inflation matches that rate, what is the real rate of return on the 2-year CD?

Include references for the source of your data. Capital Budgeting

Mike Moore’s microbrewery is considering production of a new ale called Mike’s Honey Harvest Brew. To

introduce this new offering, Mike is considering two independent projects. Each of these projects has

two mutually exclusive alternatives, and each alternative has a useful life of 10 years and no salvage

value. Mike’s MARR is 8%. Information regarding the projects and alternatives are given in the following

table.

Project/Alternative

Project 1: Purchase New

Fermenting Tanks

Alt. A: 5000-gallon tank

Alt. B: 15000-gallon tank

Project 2: Purchase Bottle-Filler

& Capper

Alt. A: 2500-bottle/hour

machine

Alt. B: 500-bottle/hour machine Cost Annual Benefit $5000

$10000 $1192

$1992 $15000 $3337 $25000 $4425 Use incremental rate of return analysis to complete the following worksheet.

Proj./Alt.

1A

1B-1A

2A

2B-2A Cost, P

$5000

$5000

$15000

$10000 Annual Benefit, A

$1192

$800

$3337 (A/P, i, 10)

0.2385

0.1601 Use this information to determine:

(a) Which projects should be funded if only $15,000 is available

(b) The cutoff rate of return if only $15,000 is available

(c) Which projects should be funded if $25,000 is vailable IRR

20%