LOS a: Describe how inflation affects the estimation of cash flows for a company domiciled in an emerging market.

Q1. In order to properly measure the cash flows of an emerging market company to consider the impact of inflation, one starts the process by constructing the:

A)   historical and forecasted financial statements in both nominal and real terms.

B)   historical financial statements using the temporal method.

C)   forecasted financial statements using the current method.

Q2. With respect to emerging market companies, which of the following macroeconomic variables has the most impact on the estimation of cash flows?

A)   Inflation.

B)   Country risk.

C)   Political risk.

Q3. When valuing an emerging market company using cash flows expressed in both nominal and real terms:

A)   both valuations are not reliable.

B)   each valuation differs by the inflation differential.

C)   both valuations are identical.

LOS a: Describe how inflation affects the estimation of cash flows for a company domiciled in an emerging market. fficeffice" />

Q1. In order to properly measure the cash flows of an emerging market company to consider the impact of inflation, one starts the process by constructing the:

A)   historical and forecasted financial statements in both nominal and real terms.

B)   historical financial statements using the temporal method.

C)   forecasted financial statements using the current method.

Correct answer is A)

Construct historical and forecasted financial statements in both nominal and real terms. Historical financial statements are translated to real terms by using the current method. Forecasted financial statements in real terms are then created and then converted to nominal terms. Finally, calculate the nominal cash flows and convert them to real terms.

Q2. With respect to emerging market companies, which of the following macroeconomic variables has the most impact on the estimation of cash flows?

A)   Inflation.

B)   Country risk.

C)   Political risk.

Correct answer is A)

Emerging markets are characterized by high inflation. Inflation affects the financial statements by creating distortions in non-monetary assets (i.e. property, plant, equipment and inventories). Cash flow projections used in valuations, as well as most financial ratios, will also be distorted.

Q3. When valuing an emerging market company using cash flows expressed in both nominal and real terms:

A)   both valuations are not reliable.

B)   each valuation differs by the inflation differential.

C)   both valuations are identical.

Correct answer is C)

In order to adjust for the influences of inflation, company cash flows will require restatement in both nominal and real terms. Construct historical and forecasted financial statements in both nominal and real terms. Calculate the nominal cash flows and convert them to real terms. Discount the nominal and real cash flows to determine their respective valuations for both terms. The valuations under both terms should be identical.