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In this question the investment appraisal is over 25 years.
Inflation for both the home country and where the investment is taking place are given.In the BPP model answer,inflation is completely ignored in discounting the cash flows even though the question says they (cashlows) are given at current prices
Only the WACC has been adjusted for inflation.
Why did they not adjust the cashlows annually for inflation?is it because 25 years is too long to individually adjust every year and hence discounting the WACC is the alternative ?
You either discount the actual (nominal) cash flows (i.e. inflate them) by the actual (nominal) cost of capital.
Or, you discount the current price (real) cash flows (i.e. ignoring inflation) by the real cost of capital (i.e. without inflation).
Both approaches will give the same answer.
Usually we use the first approach (because the second one only works when everything inflates at the same, general, rate). However here it would take forever to inflate the flows for 25 years, which is why it is more sensible to use the second approach.
If you are still unsure then look at the Paper F6 lecture on dealing with inflation where this is explained.
Thank you Sir,
So are you saying adjusting the WACC for inflation is the alternative to adjusting the cash flows for inflation and either way you will get the same answer?
Yes.
But appreciate what I said before. It would only work if everything inflated at the same rate.
In this question it works perfectly, and if you do want to try inflating all the flows and discounting at the actual WACC then you will get exactly the same answer. (Although I think you would be better just believing me, because it will waste loads of your time checking me 🙂 )
Thank you for all your help Sir..!
If you were in South Africa,I would have bought you a bottle of vintage wine from Cape Town.
You are welcome 🙂
(and if I visit South Africa ever then I will collect the wine from you 🙂 )
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