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Dear Tutor,
Thanks for last week’s advice on interest rate differentials. I still haven’t made time to watch the lecture 🙁
Inflation seems to be another topic where the rules change. Exam Q1 December 2013 Chmura co.
Year 1 10,000 batches sold
Cost per batch 115,200 MP (made up currency) – CURRENT selling price i.e. today.
> Selling price will increase 5% per year
> Inflation rate of megham in 8% per year (relevant country of MP currency)What I did to get Revenue for year 1
10,000 x 115,200 x 1.05 x 1.08 = 1,306,368 (MP ‘000)Exam solution to get Revenue for year 1
10,000 x 115,200 x 1.05 = 1,209,600 (MP ‘000)My question is, why was inflation ignored? In every NPV practice question I have done where inflation was stated, the answer has always instructed to inflate.
I know there are circumstances where inflation can be ignored if revenue and cost inflate at the same rate, and we can then use an uninflated cost of capital.
However, this question is an overseas investment where we have to convert MP to $, and we are given a $ domestic cost of capital 12%.
So I suppose my other question is, in an overseas investment, are the inflation rates only given for the purpose of calculating forecasted exchange rates? Are we not supposed to apply the inlfation rates to the revenue and cost figures?
Sorry for the long-winded question. Many thanks.
Just because the inflation rate in the country is 8% does not mean that everything has to inflate at 8% (unless the question was to tell you that was the case).
I don’t know what country you live in, but I do not believe that just because the average inflation rate in the country is (say 8%) that automatically you would increase your prices by exactly 8%!! You might put your prices up more or put them up less. Similarly it does not mean that all of your costs will go up by exactly 8%.
This question specifically tells you what the increase is in the selling price etc.. If selling prices go up by 5% then it is 5% – not 8% and then another 5% on top!!
Certainly, purchasing power parity depends on the overall inflation rate for the country.
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