Hi, I had a quick question in regards to the CFA Topic Test entitled “England” for Corporate finance (Level II Topic Test #3). In this case, question #2 asks "Prior to her first conversation with Weinberger and based on the information from Exhibits 1 and 2, England’s estimate of the 2014 economic profit for the new division (in millions) is closest to:" The solution to this answer uses the real WACC to calculate Economic Profit. However, the note in exhibit 2 clearly states that “All values are nominal except for real WACC”. Why are we using the real WACC in calculating economic profit on “Nominal” numbers? I was under the impression that when we have nominal cash flows, we use nominal discount rates and when we have real cash flows, we use real discount rates. Thanks in advance!
Don’t get mad about it, is just how the case want you to approach. I have just checked the CFAI book and there is no distinction between real or nominal wacc being used in the Economic Profit (EP) calculation. In this opportunity you must use the real wacc as the question says. I think the case wanted to test how well you can adjust measures by inflation. For example, the third question asks for the real cost of equity; to get it you just calculate the nominal cost of equity as always we do and then “deflact” it using the inflation rate provided. Remember this knowledge forever.
@Harrogath Thank you for the input but that doesn’t clarify my question. The question did not state to “use the real wacc”. If they are testing our knowledge on adjusting for inflation then why are we not making that appropriate adjustment (reason I made this post) and why are we using inconsistent measures (i.e a “real” rate with “nominal” numbers)? The CFA clearly makes the distinction in the text that nominal rates should be used for nominal cash flows and that “real” rates should be used for real cash flows (i.e inflation adjusted). The note in exhibit 2, which the question is based off of, clearly states that all numbers are nominal except for WACC. So again, why is there no adjustment needed to the nominal numbers, if we are using the real WACC, to calculate economic profit?
So are we supposed to do Real WACC + Rf = Nom WACC ?
Remember we are following orders from the case, the analyst calculated real wacc to get eva, so just do what the case ask you to do. Those cases are not necessarily real life applications. I think the real wacc was a trick to make you think how to obtain the nominal wacc, but after rethinking about it one realizes that there is no way to do it. Again note that the case reading states the analyst made that way intentionally.