- CFA Exams
- CFA Exam: Level II 2021
- Study Session 7. Corporate Finance (1)
- Reading 19. Capital Budgeting
- Subject 1. Cash flow projections

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**CFA Practice Question**

Which of the following statements is true?

B. The WACC includes a premium for expected inflation, so the higher the expected inflation rate, the smaller the value of capital.

C. Actual inflation rates, and not expected inflation rates, are important in determining the cost of capital.

D. The inflation bias can be avoided by simply building inflationary expectations into the cash flows.

A. If the projected prices reflect expected inflation, the NPV will be biased downward.

B. The WACC includes a premium for expected inflation, so the higher the expected inflation rate, the smaller the value of capital.

C. Actual inflation rates, and not expected inflation rates, are important in determining the cost of capital.

D. The inflation bias can be avoided by simply building inflationary expectations into the cash flows.

Correct Answer: D

When doing capital budgeting analysis, cash flows that reflect the effect of expected future prices in cash flows discounted at the nominal cost of capital will correct any inflation bias.

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**User Contributed Comments**
5

User |
Comment |
---|---|

sarath |
why is B wrong ? |

gsuwp |
A higher expected inflation rate means a higher discount rate for the cash flows. |

clara |
coz we don't apply WACC but projected cost of capital in calculation of NPV (see examples in reading) |

vi2009 |
C. is incorrect because we need to use expected inflation rate in projections..not current! |

killurvig |
@sarath - The Inflation is factored in the future cash flows and not the WACC. That is why B is wrong |