Omission of Inflation Adjustment on NPV and IRR Calculations | CFA® Level 1 Exam

Effects of Omitting Inflation Adjustment on NPV and IRR Calculations

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Question

In his determination of a project's NPV and IRR, a financial analyst with Smith, Kleen, & Beetchnutty indexes the project's anticipated cash flows for the expected effects of inflation. However, the discount rate applied to these cash flows does not factor an adjustment for inflation. Assuming a positive inflation figure for the every period in the project's lifespan, which of the following correctly describes the effects of the omission on the NPV and IRR calculations?

Answers

Explanations

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A. B. C. D. E. F.

Explanation

By failing to include an the effects of anticipated inflation in the discount rate applied to the project's cash inflows, this analyst is creating a situation in which the

NPV calculations will be biased upward. This is due to the fact that the project's inflows have been adjusted for the anticipated effects of POSITIVE inflation, i.e. these cash flows have been indexed upward, while at the same time the rate at which these cash flows are being discounted has not increased. In effect, the cash inflows of the project are being overstated, and this will lead to an upward bias in the NPV calculation. Remember that the Internal Rate of Return calculation does not specify an explicit discount rate, rather calculates the discount rate that equates the cash inflows of a project with its cash outflows. The fact that this analyst has not incorporated the effects of inflation into the discount rate has no bearing on IRR, because the IRR equation does not call for a discount rate.

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