1) If a company’s practice is to calculate project NPVs using nominal cash flow and a nominal discount rate, then it must have a real cash flows at the real rate then developing an inflation forecast is unnecessary. “Is thiscstatement true or false?” Why isn’t excess capacity free?
The statement is true; in nominal terms NPV is valued at the actual price and in “real” terms should be valued at a price deflated by the expected inflation. To value NPV in “real” terms the prices of the forecast include technological change, competitive situation and rate of inflation is required. In addition, accounting numberscmay not accurately reflect when revenues are received or when payments are made. NPV focuses on when money is actually received or paid a then discounts these cash flows at an appropriate rate to find whether a
project adds value to a company. This recognizes that whatever account earnings a company has, it must generate sufficient cash to pay its bills or it will not stay in business.
Why isn’t excess capacity free?
Firms tend to operate at less than full capacity. When a firm is in this state, managers encourage alternative uses of excess capacity as this can be viewed as free asset. Therefore, excess capacity is not free. It was originally accounted for when the project was first chosen; the size equipment that produced the excess
capacity was included in this project cash flows. If there are no use for the excess capacity, now or later, for the original project then the new project could use the excess capacity. But one must add that using the excess capacity on the new project that means that the original project will have to add more capacity at some point.
Where this should really be charged to the new project.
2) • “If a company’s practice is to calculate project NPVs using nominal cash flows and a nominal discount rate, then it must have a forecast for expected inflation; however, if the company discounts real cash flows at the real rate, then developing an inflation forecast is unnecessary.” Is this statement true or false? Provide
reasons for your answer.
The statement is inaccurate