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Suppose revenues and cost both are affected by 3.5% inflation p.a for 10 years with current market rates of return wacc is 12%
revenue is 8300 p.a
cost 2500 p.a1 ) Do i account for inflation
2) Does the wacc change to
(1.12/1.035)-1 = 8%
3) does fixed payments of interest grant tax savings?
1) Although there are two alternatives, usually in the exam best is to account for inflation and inflate the cash flows.
2) No, the WACC does not change. You either calculate the actual (nominal) cash flows by inflating them, and then discount at the actual / (nominal) cost of capital.
Alternatively, you use the current price flows (real flows) without inflation, and discount at the real cost of capital (which in your example would be 8%). This would be faster for this example, but in the exam it is virtually always the first way that is expected.3) Interest is always assumed to be tax allowable. However that is part of the calculation of the WACC and does not ever affect the cash flows.
(It will help you to watch the free lectures on investment appraisal with inflation and on cost of capital calculations)
Thank you very much for a quick answer will surely watch these for a better understanding
last question
a $10 million bank loan with a prevailing interest rate of 5% for the 10 years with tax rate 30%is tax saving 500 000 x 30% for all years?
With no other information, you would assume that to be the case. (The problem with a bank loan is that depending on the agreement the interest charged might not stay at 5%. In the exam you would always assume (unless specifically told otherwise) that it was a fixed rate loan and therefore the tax saving would indeed be 500,000 x 30% each year.
But, the interest savings are never ever included in the cash flows. They are accounted for within the WACC. The cost of the bank loan to be included in the WACC calculation in this case would be 5% x (1-0.3) = 3.5%
(By the way, in future if you wish me to answer a question then please ask in the Ask the Tutor Forum for F9 – this forum is for students to help each other 🙂 )
Hello,
Does that mean that the WACC is not influenced by the inflation? and why exactly? thank youIf the general rate of inflation changes in the future then the actual (nominal) WACC will change in the future. The ‘real’ cost of capital will not change.
All of this is explained in my free lectures.
If you have more questions that you want me to answer, then as I wrote above you must ask in the Ask the Tutor Forum.
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