LOS b: Discuss the effects of inflation on capital budgeting analysis.

Q1. Which of the following statements regarding inflation is TRUE? Inflation:

A)   causes the WACC to increase and the present value of the cash flows to increase.

B)   is built into the weighted average cost of capital (WACC) and thus the net present value (NPV) is adjusted for expected inflation.

C)   is already present in the future cash flows therefore they need no further adjustment.

Q2. With respect to capital budgeting, expected inflation is incorporated into the weighted average cost of capital (WACC) by:

A)   none of these since inflation is not related to the WACC.

B)   adjusting the separate component for inflation in the WACC.

C)   adjusting expected returns in response to changes in inflation.

Q3. With respect to capital budgeting and measuring net present value, to avoid biases from an increase in expected inflation, an analyst should revise:

A)   weighted average cost of capital (WACC) up and cash flows down.

B)   both weighted average cost of capital (WACC) and cash flows up.

C)   weighted average cost of capital (WACC) down and cash flows up.

Q4. An increase in expected inflation will generally:

A)   leave weighted average cost of capital (WACC) unchanged.

B)   decrease the weighted average cost of capital (WACC).

C)   increase the weighted average cost of capital (WACC).

Q5. Norine Benson is studying for the Level I CFA examination and is having difficulty with the broader concepts of capital budgeting. Her study partner, Henri Manz, tests her understanding by asking her to identify which of the following statements is most accurate?

A)   An analyst can ignore inflation since price level expectations are built into the weighted average cost of capital (WACC).

B)   For mutually exclusive projects, the decision rule is to pick the project that has the highest net present value (NPV).

C)   Replacement decisions involve mutually exclusive projects.

LOS b: Discuss the effects of inflation on capital budgeting analysis. fficeffice" />

Q1. Which of the following statements regarding inflation is TRUE? Inflation:

A)   causes the WACC to increase and the present value of the cash flows to increase.

B)   is built into the weighted average cost of capital (WACC) and thus the net present value (NPV) is adjusted for expected inflation.

C)   is already present in the future cash flows therefore they need no further adjustment.

Correct answer is B)         

Inflation is built into the weighted average cost of capital (WACC) and thus the net present value (NPV) is adjusted for expected inflation. An increase in inflation causes the WACC to increase and the present value of the cash flows to decrease.  Future cash flows such as sales revenues should be adjusted upward to reflect the affect of inflation on future prices otherwise the NPV calculation will be biased downward.

Q2. With respect to capital budgeting, expected inflation is incorporated into the weighted average cost of capital (WACC) by:

A)   none of these since inflation is not related to the WACC.

B)   adjusting the separate component for inflation in the WACC.

C)   adjusting expected returns in response to changes in inflation.

Correct answer is C)

Expected inflation is built into net present value calculations because inflation expectations are impounded in the expected returns used to calculate the WACC.

Q3. With respect to capital budgeting and measuring net present value, to avoid biases from an increase in expected inflation, an analyst should revise:

A)   weighted average cost of capital (WACC) up and cash flows down.

B)   both weighted average cost of capital (WACC) and cash flows up.

C)   weighted average cost of capital (WACC) down and cash flows up.

Correct answer is B)         

Required rates of return on investments generally exceed inflation. An increase in expected inflation will generally increase the required return on equity and debt; therefore, the WACC will rise as inflation rises. To avoid a downward bias on net present value, cash flows should be adjusted up to reflect inflation effects.

Q4. An increase in expected inflation will generally:

A)   leave weighted average cost of capital (WACC) unchanged.

B)   decrease the weighted average cost of capital (WACC).

C)   increase the weighted average cost of capital (WACC).

Correct answer is C)

Required rates of return on investments generally exceed inflation. An increase in expected inflation will generally increase the required return on equity and debt; therefore, the WACC will rise as inflation rises.

Q5. Norine Benson is studying for the Level I CFA examination and is having difficulty with the broader concepts of capital budgeting. Her study partner, Henri Manz, tests her understanding by asking her to identify which of the following statements is most accurate?

A)   An analyst can ignore inflation since price level expectations are built into the weighted average cost of capital (WACC).

B)   For mutually exclusive projects, the decision rule is to pick the project that has the highest net present value (NPV).

C)   Replacement decisions involve mutually exclusive projects.

Correct answer is C)

Because replacement decisions involve either keeping the old asset or replacing the old asset, the projects are mutually exclusive.
The decision rule for NPV is to pick the project with the highest positive NPV. Only projects with positive NPV add to the company’s value. If neither project has a positive NPV, neither project should be chosen. Because the WACC is adjusted for inflation, the analyst must adjust project cash flows upward to reflect inflation. If the cash flows are not adjusted for inflation, the NPV will be biased downward. (Reverse the preceding logic for deflation.)

a

a

c

b

c

thx

thanks

thanks