Question: The company s financial manager and accountant were arguing over how
The company's financial manager and accountant were arguing over how to properly take account of inflation when analyzing capital investment projects. The accountant typically included estimates of price-level changes when estimating and projecting future cash flows. For this, he took the government's gross domestic product (GDP) price deflator as the best estimate for the future inflation rate. This was 5 percent per year. He therefore believed that the company's discount rate should take into account inflation and that the standard 12 percent they used should be increased by 5 percent to avoid biasing the analysis and overestimating the net present value of the project. The financial manager disagreed, arguing that what the accountant was proposing would really underestimate the net present value. The 12 percent discount rate had been computed by taking the firm's 10 percent expected borrowing rate from its bank, its estimated cost of equity of 15 percent, and a 25 percent corporate tax rate. Who is correct in this argument? Please elaborate.
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