Following an internal investigation into her professional business activities, a financial analyst with Smith, Kleen & Beetchnutty admits that in her NPV and IRR calculations, she has failed to index all cash flows for the effects of anticipated inflation. However, the analyst claims that the discount rate she has used in her calculations does take into effect anticipated inflation.
Which of the following correctly describes the effects this will have on the NPV and IRR calculations?
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A. B. C. D. E. F.C
By failing to index the cash flows of projects in her NPV analysis, while at the same time including an adjustment for inflation into the discount rate, this analyst has biased the NPV calculation downward. This is because the cash inflows are being understated by the inflation-adjusted discounting. This phenomenon will skew the NPV figure downward. Remember that while 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 remains that the cash flows in the calculation have not been indexed for the effects of positive inflation. What has happened here is that cash flows have been understated, and this will bias the IRR calculation downward.