For a given project, a company overstates the rate of inflation used in estimating the projects cash flows but appropriately estimates the projects cost of capital. The calculated net present value (NPV) and internal rate of return (IRR), respectively, for the project will most likely be: NPV IRR A. Overstated Overstated B. Overstated Unaffected C. Unaffected Overstated D. Unaffected Unaffected
When you overstate the Inflation in estimating project’s cash flows - they are likely to be higher than expected. Rate of discounting (Cost of capital is right). So you would have both an overstated NPV and overstated IRR. Choice A???
“appropriately estimates the project’s cost of capital” —> I would conclude that IRR is unaffected. NPV is overstated since the CF are overstated. would go with b.
barthezz – wouldn’t IRR be affected because the cash flows are higher?
cpk - that is the question. your conclusion makes definitely sense. when they say: “appropriately estimates the project`s cost of capital” is this meant to be ONLY with regards to the calculation of the NPV and the IRR computation is a SEPARATE thing…
The ans I have here is C. I guess it is a printing mistake.
lol i thot of C but doesn’t make sense… With NPV, the cash flow is unaffected because, say, ur getting the same amount of $1000 for 5 years. Then u discount using k. NPV is unaffected. With IRR, the IRR that u obtain contains inflation, so the IRR is overstated…
Questions like this are obnoxious because it seems like there is so much room for interpretation. I agree with CPK… my initial inclination is to say A. ancientmtk, I think the point of contention with regards to NPV has to do with your assumption that the amount to be received is a fixed amount (as in your example, $1000 for 5 years) However, say I have a model that projects cash flows. Each year, I am selling a given quantity of a product for a given price. Say I build an inflation rate into my projection of the product price, so that it is increasing over time. If I overstate that inflation rate, then the revenue (price x quantity) I project will be overstated. I will be overstating my cash flows, and my NPV will be overstated as a result. Of course, this may be reading too far into the question, and in the eyes of CFAI, you may be interpreting the question correctly. Hard to say.