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CFA Level I · CFA Level I Exam · Capital Investments and Capital Allocation

A firm is evaluating a project whose cash flows are in nominal terms and include expected inflation of 3% a year. The firm's nominal required return is 11%. Which approach is most likely to avoid a capital budgeting error?

Discount nominal cash flows at the nominal rate of 11%. Inflation treatment must match between cash flows and the discount rate. Mixing nominal flows with a real rate overstates NPV, while mixing real flows with a nominal rate understates it.

  1. ADiscount the nominal cash flows at the nominal rate of 11%Correct
  2. BDiscount the nominal cash flows at the real rate of about 7.8%
  3. CDiscount the real cash flows at the nominal rate of 11%

Explanation

Cash flows and discount rates must be consistent: nominal cash flows use a nominal rate. Real rate is 1.11/1.03 - 1 = 7.8%. Discounting nominal flows at the real rate overstates NPV, and discounting real flows at the nominal rate understates it.

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