A firm is considering investing €500,000 in a new tire assembly line. The project will generate a raw, unadjusted cash flow of €235,000 annually. The company's standard interest rate without inflation is 5%. However, the finance department expects a steady inflation rate of 1% and wants to evaluate the project using "euros taking inflation into account" (actual quantities) rather than modifying the cash flows directly.
To correctly assess this project using the dynamic NPV method, what must the financial analyst do to the interest rate, and what is the exact rate they should apply?

Question

Answer

Subtract inflation from the cost of capital ( 5% - 1% = 4% ) to account for the loss of purchasing power.

Answer

Apply the inflation rate to the cost of capital using the formula ( K-g)/(1+g) , resulting in a global rate of 3.96%.

Answer

Add the inflation rate to the cost of capital ( 5% + 1% = 6% ) to use a higher rate due to inflation.

Answer

Maintain the 5% cost of capital but multiply the final NPV result by  (1+0.01)^n

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A firm is considering investing €500,000 in a new tire assembly line. The projec...

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