- This topic has 5 replies, 2 voices, and was last updated 1 year ago by
.
- Posts
Q) A project has an initial outflow at time 0 when an asset is bought, then a series of revenue
inflows at the end of each year, and then finally sales proceeds from the sale of the asset.
Its NPV is £12,000 when general inflation is zero % per year.If general inflation were to rise to 7% per year, and all revenue inflows were subject to
this rate of inflation but the initial expenditure and resale value of the asset were not
subject to inflation, what would happen to the NPV?A The NPV would remain the same
B The NPV would rise
C The NPV would fall
D The NPV could rise or fallC is the correct answer
Hello tutor!!!
Firstly I also choose option C but then I thought if we discount the inflated cash flows by NOMINAL RATE and discount the sales proceeds by Real rate (because sales proceeds are not inflated and I assume that 12,000 is current value and also a future value and does not effected by inflation) then NPV would remain the same that’s why I reverse my decision and choose option A but they are saying discount the sales proceeds too by money rate which I don’t understand why.
Could you please explain ?If the general rate of inflation increases, then the actual (nominal) cost of capital will increase.
If the revenue flows increase also at 7%, then the PV of the revenue flows will not change (they are inflating at 7% but are discounted at a cost of capital that is higher than 7%).
However the final sale proceeds will stay the same, but will be discounted at a higher cost of capital and therefore the PV of the final sale proceeds will be lower.
The PV of the initial outflow will obviously stay the same.
So the only PV that will change will be that of the final sales value. That will be lower and therefore the NPV will be lower.
Yes I already understood the logic of the answer but my question is why should not we discount the scrap proceeds by real discount rate ?
The resale value does not inflate and is therefore discounted at the actual / nominal cost of capital. Discounting at a higher cost of capital (because with higher inflation there will be a higher actual cost of capital) results in a lower present value.
- The topic ‘Investment Appraisal Kaplan kit MCQ’ is closed to new replies.