Q8. Wavington Enterprises is headquartered in an emerging market nation that is expected to have 27% inflation over the next year. Charleston Johnson expects the local government to be successful in bringing inflation under control, and anticipates that it will fall to 20% in the second year and 10% in the third year, where he expects inflation to stabilize. Johnson is considering an investment in Wavington, and has calculated the real weighted average cost of capital (WACC) for Wavington at 8%. Johnson states:

Statement 1:    The nominal WACC for Wavington next year is 35%.

Statement 2:    The firm value will be approximately the same using either the real or nominal approach to valuation.

With respect to these statements:

A)   only one is correct.

B)   both are incorrect.

C)   both are correct.

Q9. Wavington Enterprises is headquartered in an emerging market nation that is expected to have 27% inflation over the next year. Charleston Johnson expects the local government to be successful in bringing inflation under control, and anticipates that it will fall to 20% in the second year and 10% in the third year, where he expects inflation to stabilize. Johnson asserts that the financial ratios of Wavington will be the same in both the real and nominal approaches. With regard to this statement, Johnson is:

A)   correct because the underlying operations of the firm are unaffected by valuation methodology.

B)   correct because the rate of inflation used in calculating the components of financial ratios is the same for all components.

C)   incorrect because cash flow forecasts in real terms are generally more accurate than cash flow forecasts in nominal terms.

Q8. Wavington Enterprises is headquartered in an emerging market nation that is expected to have 27% inflation over the next year. Charleston Johnson expects the local government to be successful in bringing inflation under control, and anticipates that it will fall to 20% in the second year and 10% in the third year, where he expects inflation to stabilize. Johnson is considering an investment in Wavington, and has calculated the real weighted average cost of capital (WACC) for Wavington at 8%. Johnson states: fficeffice" />

Statement 1:    The nominal WACC for Wavington next year is 35%.

Statement 2:    The firm value will be approximately the same using either the real or nominal approach to valuation.

With respect to these statements:

A)   only one is correct.

B)   both are incorrect.

C)   both are correct.

Correct answer is A)

The nominal WACC for Wavington next year is (1.27 × 1.08) – 1 = 37.2%, not 35%. Johnson is incorrect regarding Statement 1. He is correct regarding Statement 2 that the nominal and real valuation approaches will produce approximately the same result.

Q9. Wavington Enterprises is headquartered in an emerging market nation that is expected to have 27% inflation over the next year. Charleston Johnson expects the local government to be successful in bringing inflation under control, and anticipates that it will fall to 20% in the second year and 10% in the third year, where he expects inflation to stabilize. Johnson asserts that the financial ratios of Wavington will be the same in both the real and nominal approaches. With regard to this statement, Johnson is:

A)   correct because the underlying operations of the firm are unaffected by valuation methodology.

B)   correct because the rate of inflation used in calculating the components of financial ratios is the same for all components.

C)   incorrect because cash flow forecasts in real terms are generally more accurate than cash flow forecasts in nominal terms. Correct answer is C)

In general, the ratios based on cash flow forecasts in real terms are accurate while ratios based on nominal forecasts are incorrectly estimated.