Fuel it 12/00

If there is no inflation then it is impossible to deal with inflation.
However in any exam question at P4 there is almost always going to be inflation.

Usually we need to calculate the nominal (actual) cash flows and discount at the nominal (actual) WACC.

This question was unusual in that although you could certainly have done the above, it would have taken ages because of the time period being so long.
Because everything inflated at the same rate, it is easier to take the real flows (in the absence of inflation) and discount at the real cost of capital.

A few things:

Firstly, APV is a better approach only when the gearing of the company is changing a lot. I know that the investment is a lot, but we don’t know the existing value of the company and so we don’t know if the change in gearing is a lot or not.

Secondly, usually if an APV approach is required then the question tells you to use it. Here it did not.

Thirdly, to use APV we would need to know the asset beta of the projects and we don’t. (I know that we do know the equity betas including the project and the gearing, but we would need to know and equity beta for the project itself and we don’t have enough information)

Finally, the question (as is always the case in P4) asks you to state your assumptions. So here, if you had tried to use an APV approach you would still have got credit, even though strictly it would not be valid for the reasons I have listed above.