Inflation Chapter 22 Full Test Bank

Chapter: Chapter 22: Inflation

Multiple Choice

1. Given the following information, compute free cash flow (FCF) in real terms: real growth is 3 percent, real ROIC is 12 percent, real NOPLAT is $5,000, real net working capital from the previous year is $2,000, the inflation index last year was 164, and the inflation index this year is 192.

a) $770.83

b) $2,958.33

c) $2,229.17

d) $3,458.33

Response: [FCF^R = (1 – 0.03/0.12) × $5,000 – $2,000 × (1 – 164/192) = $3,458.33]

2. A firm begins with nominal net working capital NWC^N_t–1 = 200 and then increases it to NWC^N_t = 250. The price index increases from IX_t–1 = 144 to IX_t = 166. Based on this information, what is the real investment in NWC in year t?

a) 9.51

b) 10.84

c) 30.12

d) 49.73

Response: [

]

AU: Please: Rekey equation above: Run in 1st line of text after opening bracket. In all lines, please set R as superscript; in 1st, 2nd, 3rd, 5th, and 6th lines, set t as italic subscripts. Change hyphens to minus signs, insert spaces around operators (except in subscripts), and run in closing bracket.

3. For which of the following is a nominal modeling application preferred to a real modeling application?

a) EBITDA.

b) Financial statements.

c) Investments in working capital.

d) Capital expenditures.

Response: []

4. Which of the following is NOT one of the steps in the five-step approach managers should employ to combine nominal and real forecasts?

a) Build financial statements in real terms.

b) Build financial statements in nominal terms.

c) Forecast operating performance in nominal terms.

d) Forecast the future free cash flows in real and nominal terms from the projected income statements and balance sheets.

Response: [The five steps are: 1. Forecast operating performance in real terms.

2. Build financial statements in nominal terms.

3. Build financial statements in real terms.

4. Forecast the future free cash flows in real and nominal terms from the projected income statements and balance sheets.

5. Estimate DCF value in real and nominal terms.]

5. If the nominal weighted average cost of capital (WACC) is 24 percent and inflation is 16 percent, then the real WACC is closest to:

a) 7 percent.

b) 8 percent.

c) 13 percent.

d) 15 percent.

Response: [1.24/1.16 – 1 = 0.069 or 6.9%]

6. Which of the following are true about inflation?

I. It depresses market valuations.

II. Investors tend to correctly perceive inflation.

III. It does not affect the cost of capital in real terms.

IV. It can affect the real-terms cash flows generated by companies.

a) I and II only.

b) I and IV only.

c) II and III only.

d) III and IV only.

Response: [Investors tend to misjudge inflation. Inflation increases the cost of capital in real terms.]

7. With respect to growth and operating margins, which is/are likely to be overstated in times of high inflation?

a) Growth only.

b) Operating margins only.

c) Both growth and operating margins.

d) Neither growth nor operating margins.

Response: []

True/False

8. An analyst should make financial projections of income statements and balance sheets for a valuation in a high-inflation environment by simply projecting all items on a nominal basis.

Response: [High-inflation environments require a hybrid approach because each single approach has drawbacks.]

9. Inflation is often persistent and difficult to fix, stretching out over several years as in the 1970s and 1980s, because suppressing it requires strict and unpopular government measures.

Response: []

10. Historical data shows that inflation leads to lower value creation in companies, because it erodes real-terms free cash flow (FCF) and increases the cost of capital.

Response: []

Short Answer

11. What are the two indirect cash flow effects of inflation that depress value?