Reading 31- LOS b ～ Q1－5

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

B)   If the change in current liabilities is greater than the change in current assets, it means that additional financing was needed and there is a cash outflow.

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

D)   Replacement decisions involve mutually exclusive projects.

The correct answer was D)

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 a neither project has a positive NPV, neither project should be chosen. The statement about net working capital (NWC) is stated in the reverse of how we usually think of it: D in NWC = D_{Current Assets} – D_{Current Liabilities}. Here, the change in current liabilities exceeds the change in current assets and the result is negative, meaning the project frees up cash, creating a cash inflow. 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.)

2．An increase in expected inflation will generally:

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

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

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

D)   have an uncertain affect on weighted average cost of capital (WACC).

The correct answer was 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.

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

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

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

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

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

The correct answer was A)

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.

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

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

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

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

D)   dividing it into the each cost component.

The correct answer was A)

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

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

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

B)   is not a concern in the capital budgeting process because the time horizon for the analysis is typically short.

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

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

The correct answer was C)

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.