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Hi,
I am confused regarding the real v money method.
I don’t understand the difference between the two as the two methods effectively give the same answer!
If they give same answer , why is there 2 method, I do understand one is with inflation and other without but if both give the same answer what’s the point of the two different methods?
Sorry if I’m missing something fundamental but if someone could explain that would be great!
Thanks
Gill
Since you asked in the Ask the ACCA Tutor forum – the ‘someone’ is me (because I am the F9 tutor) 🙂
In the exam we always discount at nominal (i.e. actual) cash flows at the nominal (i.e. actual) cost of capital, unless specifically told to do differently, which is not very often.
Both approaches would however give the same answer but ONLY if all the flows inflated at the same rate as the general rate of inflation (which, again, rarely happens in the exam).
The real point of understanding it is as follows (but is really for written parts if you get the chance or are asked about it):
One of the big reservations in discounting is estimating the rate of inflation (in order to ge the actual cash flows), and the fact that whatever the cost of capital is at the moment, it obviously stands to change in the future (and we ignore that).
However, if it were the case that everything were to inflate at the same, general, rate of inflation, then we could ignore inflation completely and discount the flows without inflation at the cost of capital without inflation (i.e. the real cost of capital).
So in theory, the two ‘big’ reservations that I mentioned in the previous paragraph are (again in theory) not a problem at all – as inflation goes up and down, so too will the actual cash flows, and so too will the actual cost of capital.The reason I show the numbers in my free lecture is really to ‘prove’ what I have just written, rather than just give a ‘rule’ – it is always dangerous to write something in the exam because you have learned it, if you don’t really understand it.
I hope all that makes sense. Do ask again if not 🙂
Hi john,
Many thanks for your promt reply.
So do both discount rates money and real include the general rate of inflation in the cost of capital?
Is the difference between them is tat nominal cash flows include specific rates of inflation in calculation of cash flows and discounted at nominal DF ( which includes general inflation) versus real rate which cash flows don’t include inflation and discounted at real rate which include general rate of inflation?
Sorry-I find the rest of f9 ok just this part puzzles me for some reason!
No – the real rate excludes inflation.
The nominal (actual, or money rate) includes general inflation ( and so this will change as the general inflation rate changes)
1. Hi john, that means when we calculate the inflation rate in the calculation of cashflow, we were using real rate ? Or nominal rate ?
2. Moreover just by looking at the question how do we differentiate whether its real or nominal rate ?
Unless the question says to do differently (or if it is a perpetuity) then we calculate the nominal (actual) cash flows by inflating them, and then discount at the nominal (actual) cost of capital.
All of this is explained, with examples, in my free lectures for both AFM and for FM (because this is revision from Paper FM (old F9) !!
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