Which of the following statements about the effect of inflation on the capital-budgeting process is mostaccurate？

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 3)

Which of the following statements about the effect of inflation on the capital-budgeting process is mostaccurate？

Statement 1: Inflation is reflected in the WACC, but future cash flows should still be adjusted when calculating the NPV.

Statement 2: Inflation will cause the WACC to decrease.

Statement 3: Inflation tends to exert upward pressure on the NPV.

Statement 4: Because the IRR does not depend on the WACC, inflation has no effect on it.

A) Statement 1 only.

B) Statements 2 and 3.

C) Statements 3 and 4.

D) Statements 1 and 2.