Easy Capital Budgeting Q

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

C? WACC has the cost of debt and cost of equity which has the infl effects embedded in it (via the RFR), so WACC DONW Cash is also down as Infl increases, due to Wealth effect.

NPV has decreased in real terms. Thus we should increase the NPV. Increase the cash flow and decrease the WACC. So A Anyway, its kind of guess :smiley:

D i


Keep guessing…

The correct answer is B. Since inflation is increasing you would increase your WACC and increase the cash flows because nominally the cash flows will be higher due to the inflation.

OOPS… I did not read the “an analyst should revise”. So my ans © is exactly oppsoite of the true ans of (B).

Hmmm… waiting for the lightbulb. Dinsesh help me. Don’t you make a downward adjustment for expected inflation?

I could us a good explanation too…

PINK - here is what I think Since you though the inflation was going to be 3% and you estimated WACC and Cash flows as per that inflation extimates. Now if the expected inflation has increased, the anslyst must increase the cash value and increase the WACC to factor for the new increased inflation. Because an inflation og 10% (when you expect it to be only 3%) would downward press the WACC and cash esltimates. Hence to remove the bias, we ‘UP’ it up

Per Schweser, 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. I think you guys are taking one step too far. Basically, the adjustments have not yet been made for the effects of inflation. So you as an analyst have projections, but you have higher expecations for inflation, you would increase the WACC estimate, and increase the cash flows

cash flows increase in nominal terms as inflation increases -> B

Really? That seems to be a big assumption that the analyst already made an adjustment for inflation. Is this question legit or am I just upset as I got it wrong?

makes sense. Thank you.