Relevant Cash Flows for DCF – Inflation effective rates

1. says

Dear Sir,

You are kindly requested to response in my query below in regards to the question 5b of the inflation – effective rates:

We have discounted the operating profit of \$60 x 2.487 annuity rate ( but the cost of capital is 15% so 2.283 annuity) and then again, we discounted the NPV by the effective rate which includes both rates of inflation and cost of capital.

I did not understand the logic and I have somehow stuck on this.

• says

I think maybe it would be helpful for you to watch the lecture again.

Usually, we discount the actual (nominal) cash flows (i.e. after inflating them) by the actual (i.e. nominal) cost of capital.

The alternative (which is very rarely relevant in the exam) is to discount the real cash flows (i.e. the current price flows, ignoring any inflation) at the real cost of capital (the effective rate, the cost of capital with inflation ‘removed’).

In part (b) of the example, the real/effective cost of capital is 10% and therefore the 3 year annuity factor at 10% is correct at 2.487.

However, it is very rarely in the exam that this is relevant (because, as I state in the lecture) it only works if all the cash flows inflate at the same general rate of inflation).

Usually in the exam, you need to inflate the flows (to get the actual/nominal cash flows) and then discount them at the actual/nominal cost of capital.

2. says

Hi John,

Thank you so much for the easy to follow lecturers. I am however, worried that you do not seem to meantion the fishers equation in all your lectures relating to inflation yet nominal and real interest rates are a CONSTANT FEATURE of the exam. Can l assume that your formula on page 52 of the lecture notes(1+e=1+m/1+i) is the same as the Fisher equation. l have a textbook from BPP but would rather stick to Open Tuition(especially at this 11th hour) so please advise on this.

Thanks

• says

Although the examiner often (but certainly not always) refers to nominal and real costs of capital, it is overdoing it to regard it as a constant feature (or to regard it as a major part of the question)!

I make it clear in the lecture that we always discount the actual/nominal cash flows at the actual/nominal cost of capital unless specifically told to do otherwise. (On only one occasion ever have you also been told as a separate part of the question, to also discount the real cash flows at the real cost of capital.)

Otherwise the only relevance has been that on one or two occasions you have been given the real cost of capital and therefore needed to calculate the nominal cost of capital.
Again, in the lecture I explain the reasoning and how to do this, and what to watch out for.

(It is the Fisher formula, but you are right – I will update to use his symbols. He did not used to give the formula (and I think the symbols he uses are very odd ) but it would be better if I used his symbols.)

• says

Thanks, John l guess its just the 11th hour panick, your videos clearly address the issue l was raised. Thanks a lot.

3. says

Dear John,

Please I require some explanation on cash conversion cycle and the calculation of the ratios. I listened to your F9 lectures but I am still struggling to understand these.

Inventory days = 15
Receivable days =10
Payable days = 14

Cash conversion cycle is 11 days.

This is how I interpret this, in 25 days I get cash, however the first 14 days out of the 25 days I have to pay out cash, so I still need to wait 11 days to get cash back? but I really still need to wait the whole 25 days to get back cash regardless of the fact that the first 14 days I pay out cash. Please help as I am really confused!

Also for the ratios, say receivables days 24,000/50,000 (Receivables/Sales)This just tells me that receivables is 48% of total sales. when I multiply it by 365 days then what does that mean? I don’t see how it means it takes 175.2 days to collect sales. Rather, I interpret this as receivables are outstanding for 175.2 days out of the whole year.

Please help explain from different angles, I’m sure I will get it once you explain vividly to me John M.

• says

In future please post questions either under the relevant lecture, or (if you want me to answer) in the Ask ACCA Tutor forum for F9. This question has nothing to do with relevant cash flows for DCF.

The operating cycle is the time that you are without the cash – i.e. the time between receiving the cash and paying out the cash.
Our bank balance only falls when we pay out to buy the materials, which is in 14 days. The bank balance goes up again when we receive the cash from our customers from selling the goods, which is in 25 days. So we are without the cash for 11 days.

If we have sales of 50,000, the the sales per day are 50,000/365.
If the receivables are 24,000 at the end of the year, then it means we are owed for sales for 24,000 / sales per day. That comes to 175.2 days. So it means that we are allowing customers to take 175.2 days to pay us.

• says

Thanks. Well i tried to, but it kept logging me off. And i have to be logged on to post a comment. This was the only page that didn’t log me off.

• says

try another browser.. we can’t replicate the problem about getting logged off.. maybe some security settings on your PC do it.. not sure

4. says

When to ignore fixed costs.Thanks your lectures are really helping me.

• says

Fixed costs are only relevant if the total will change as a result of doing the project.
Just absorbing or charging some of the costs to the new project (for profit purposes) is not relevant because it does not mean that the total is changing – it is just being shared differently.

5. says

Thanks alot! I learnt this in class, but I had no idea what it was. Even during the revision, I was just wondering what was going on :/
And, now it’s so clear…. Brilliant lecture!

• says

Have you looked at the technical support page?

The lecture is working fine and does not need fixing.

6. says

Hi ?john.I have a question about nominal rate of interest.It seems that the cost of capital given in the NPV question is the nominal rate of interest (is it?),then why the cost of capital given in the question doesn’t increase as the rate of inflation increase every year? THX John.

• says

Er…Actually I mean we have to multiply contribution by (1+inflation rate) every year.Why doesn’t the cost of capital do so ?

• says

The cash flow keeps increasing, but the rate of inflation stays the same.

The cost of capital will only change if the general rate of inflation changes. (Look at the Fisher formula – the cost of capital depends on the rate of inflation. If the rate of inflation is constant then the cost of capital is constant)

7. says

in investment appraisal , we have to give tax payment on cashflows which are sales less variable cost less fixed cost , my question is , the scrap value should be added in the final year after the tax payment ? scrap value and working capital adjustments should be included after we made the tax payment ? kindly guide me , what would be the EXACT FORMAT of net present value /investment appraisal ?

• says

The lecture on Relevant cash flows for tax gives the EXACT format.

First we list the operating cash flows (sales less variable costs less incremental (extra) fixed costs)
Then we calculate the tax on the operating flows.
Then we list the capital flows (cost and scrap proceeds)
Then we calculate the tax saving on the capital allowances (or ‘tax allowable depreciation’)
Then we bring in the working capital flows (at the end, because they have no tax effect)

• says

Thanks its really helpful , my another question is when calculating ROCE/ARR , we make operating cashflows (sales less variable cost less extra fixed cost) into accounting profit i.e operating cashflows less accumulated depreciation divided by projests life equals to accounting profit , right? my question is that whether to include scrap value in the operating cashflows too ?

• says

Scap proceeds is not an operating flow, but it is taken into account when calculating the depreciation.

8. says

the discount rate /cost of capital given in the investment appraisal (in which we discount cashflows for present values) is a Nominal rate (money term) ? what basically it is ? nominal ? and is this a before tax or after tax cost of capital ? n my other question is if we r given general inflation so we have to convert Real into Nominal rate ? kindly make it clear . with exaples , it confuses me so much .

• says

In F9 we always discount the actual (nominal) cash flows at the actual (nominal) after tax cost of capital.

If the cash flows are given in real (current price) terms the we need to inflate them to get the actual (nominal ) cash flows.

If the cost of capital is given in real terms ( the ‘real’ cost of capital) we need to use the formula (with the inflation rate) to get the actual (nominal) cost of capital.

We always use the after tax cost of capital.

For examples watch the lecture again and see the course notes.

• says

if v have to inflate the discount rate (to make in money terms) we will use Fishers formula right ? and we will do this if we have General inflation given in the question and clearly stated right ? and the inflation rates given for other elements like sales 5%, material 2% labour 2.5% are called Spefic inflation rates ?

• says

Yes – everything you have written is correct

• says

Thanx it made me clear .

9. says

Seemingly complex things made ordinary. You are a great teacher. It flows like a beautiful poem!

Thank you ver much OT team.

10. says

Hi John:
Thanks for your lecture with such clarity. As it relates to inflation, June 2012 question # 1, how are the inflated selling and variable costs arrived at from years 2 to 4? we are given selling prices from years 1 to 4 being \$25, \$24, \$23 & \$23 with 4% inflation the answers given are \$26 (ok), \$25.96, \$25.87, & \$26.91. Variable cost given for years 1 to 4 are \$10, \$11, \$12 & \$12.50 at 2.5% inflation. answers given are \$10.25 (ok), \$11.56, 12.92 & \$13.80.

Thank you

• says

Inflation on selling prices is 4% per year.

So the selling price in year 2 is 24 x 1.04^2 and in year 3 is 23 x 1.04^3 and so on.

• says

Thank you. I did ” x 1.04″ only and not “1.04^2″ etc. Is there a time when you use only “x 1.04″ for each year?

• says

No – you multiply by 1.04 for each year of inflation.

11. says

I agree with what my dear brother says. I am from pakistan and even here the teachers are not very talented if i may compare them with John! thank you John for such wonderful lectures.

12. says

i study at india where there is a great lack for good teachers and i have just(4days) come to know of your videos and already am gonna complete watching all the sessions-they are so addictive which also means you are still to do a lot of marketing about these lectures but i can tell you they ll be more than just a soaring hit……………………!!!!!!!!!!!
kudos u guys rock…………………
the part when you said about bringing

1.05/1.15 = 1/1.15/1.05 …..it hit the penultimate part of my understanding of the fischer’s formula…………