CFA Practice Question

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CFA Practice Question

The impact of price level changes on the NPV of a project would be:

A. negative if there was deflation.
B. negative if there was price stability.
C. positive if there was deflation.
Correct Answer: C

User Contributed Comments 12

User Comment
kalps Positive if deflation becos inflation has been built into our model therefore lower prices would be positive (if looking at costs)
synner deflation, lower nominal interest rate, lower cost of capital. so NPV positive.
sarath deflation => nominal interst rate < real interest rate => NPV increased..
jmcarr02 shouldn't changes in the price levels affct both the cost fo capital and the projected cash flows (costs will be higher or lower!) ? so the impact is uncertain...
jmcarr02 sorry, I was wrong... since there is deflation, WACC is lower and CFs are higher (if we suppose the company can maintain the same sale level and the costs get lower).
Narsi This seems to be against what is said in the notes. WACC already takes into account price level changes and cash flows are usually stated in nominal terms. Assuming project has positive cash flows deflation would reduce nominal cash flows and with WACC unchanged it's going to affect NPV negatively.
vi2009 NPV increases (gets "better") in deflationary times. Inflationary time, more expenditure, so cash flow will be negatively impacted as a result of which, NPV under inflationary time will decrease or negatively impacted!
DaBlasta2 impact of inflation/deflation on NPV derives from impact on depreciation tax shelter...Higher than expected inflation reduces the value of the depn tax shelter and tax saving, therefore reduces NPV...lower than expected inflation/deflation has opposite effect ie increases NPV thru increased dpn tax shelter
VenkatB DaBlasta2- Very good point!
BryonBUI The effects come from 3 sources: Depr. tax shelter, value of fixed payments to bondholder and Revenue/cost impact non-uniformity (LOS28b). It's difficult to tell the overall direction
khalifa92 the key take away here is the effect of inflation/deflation on tax shelters created from depreciation.
CF = ( S - C - D ) ( 1-t ) + D

the removal of D reduces the amount being taxed, and then putting it back because its non cash charges.
dwalters mathematically : when inflation [up] => WACC [up] and as WACC is in the denominator of the NPV formula => NPV [down]
when there is deflation the opposite occurs i.e. WACC [down] =>NPV [up] ( i.e. a positive impact on NPV)
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