Chapter 4 - Further DCF aspects

Question 1

Describe Inflation

Answer 1

The general increase in prices in an economy.

Question 2

Describe the two steps of the “Real Method” for calculating the NPV

Answer 2

• Do Not adjust cash flows for inflation

- Discount cashflows at the REAL cost of capital

Question 3

Describe the two steps of the “Money Method” for calculating the NPV

Answer 3

• Adjust cash flows for inflation

- Discount cashflows at the MONEY cost of capital

Question 4

If the question states ‘cost of capital’, what can be assumed that this rate is?

Answer 4

The money (nominal) rate

Question 5

What is described below?

This reflects the money return that investors require and includes the additional return that investors will want to compensate for inflation

Answer 5

Money cost of capital

Question 6

What is described below?

This reflects the return that investors require over and above any inflation that exists in an economy

Answer 6

Real cost of capital

Question 7

If there is a single rate of inflation applicable to all cash flows what happens to the NPV’s?

Answer 7

The NPV in real terms will equal the NPV in money term

Question 8

If there is more than one inflation rate given in a question e.g. sales inflate at 5% each year but material
costs only inflate at 3% each year, what is the only approach that gives the correct answer?

Answer 8

The money approach

Question 9

An interest rate and the company’s weighted average cost of capital (WACC) are both what kind of rate?

Answer 9

Money rates

Question 10

Express the relationship between the real and money cost of capital.

Also give each term in the formula

Answer 10

(1 + i) = (1 + r) (1 + h)

i= Money rate
r= Real rate
h= General inflation rate