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Hello SIR.
How do I discount real cash flows with a real cost of capital in calculating the NPV of an investment project? There is a question called PINK Co [requirement ‘b’] where real net present value of Pinks Co’s investment project is being asked.
Can you please advise whether how do I calcuate the “Real cash flows before tax” which I assume does not need to adjust for specific inflation?? This means that I have to adjust for general inflation only rather than specific inflation to get the “real cashflows before tax”?
I assume that you are referring to the question in the March?June 2019 exam. (In future please say which exam – I cannot remember the name of every question that has ever been set 🙂 )
Part (a) (i) requires you to calculated the nominal cash flows and discount at the nominal cost of capital. So we inflate using the actual rates of inflation for each item, and discount at the actual WACC. This is the normal way of dealing with inflation and is what is normally required.
Part (b) (ii) is rarely asked (and is actually a little bit silly – that is why it is much fewer marks). However to get the real cash flows we take the nominal cash flows and remove the general rate of inflation (by dividing by 1.037, 1.037^2, and so on). We then discount at the real cost of capital which we would get from using the Fisher formula on the formula sheet. However for this question we do not need to calculate the real cost of capital ourselves because it is actually given in the question.
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Why do we deflate general inflation from nominal cashflow to get real cashflow since we had never incorporated general inflation in the calculations, but rather we had incorporated specific inflation for each variables to get the inflated values of nominal cash flows.
I know that real cost of capital does not account for inflation while the nominal cost of capital does account for inflation but it is specific inflation, not general inflation.
What is the reason Sir, deflating general inflation & not specific inflation? This confused me!
I saw your lecture already but still confused 🙁
Discounting at the real rate is only valid if the flows are inflating at the real rate of inflation.
That is why we deflate the nominal flows at the real inflation rate and then discount at the real cost of capital.
Again it is a strange thing for the examiner to ask for and although he has been the examiner for all over 10 year, he has asked in twice (both times as a small part of a question) and so could ask it again.
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