Assume that a project's sales revenues are expected to increase more rapidly than product costs, but the project's cash flows have been represented as a fixed annuity when calculating NPV. Which one of the following problems might exist within this analysis?
A) Nominal cash flows are possibly being discounted with a real rate.
B) Real cash flows are possibly being discounted with a nominal rate.
C) Nominal cash flows are possibly being discounted with a nominal rate.
D)Real cash flows are possibly being discounted with a real rate.

Question

Quizplus · Accepted Answer

If the sales revenues are expected to increase more rapidly than product costs, it implies that the real cash flows are increasing. However, if the cash flows have been represented as a fixed annuity, it implies that the nominal cash flows are constant. Therefore, if the nominal cash flows are being discounted with a nominal rate, the analysis will be correctly discounted. However, if real cash flows are being discounted with a nominal rate, the NPV will be overstated. This is because the nominal rate includes an inflation premium, which assumes that sales revenues and product costs will grow at the same rate. But if sales revenues are expected to grow at a faster rate, then the real cash flows will grow faster than the inflation premium, resulting in a higher NPV. Therefore, the correct answer is B.

Assume That a Project's Sales Revenues Are Expected to Increase