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Pinks Co (March/June 2019)
QUESTION 32(a)(ii)Hi,
“If an exam question contains specific inflation rates and also provides a general rate of inflation, the nominal terms approach is quicker and is recommended, since nominal cash flows must be calculated using specific inflation before deflating these by the general rate of inflation to give real cash flows for use in a real terms approach. Note that if a real terms approach is adopted, the specific inflation rates cannot be ignored.” – ACCA technical article
Why can’t we just take the current cash flows (ie before taking into account any inflation) and discount it at real cost of capital?
I tried doing that and got different answer which is wrong. I thought we discount real cash flows at real cost of capital (which is what I was doing)?
Is it because the current cash flows are not the same as real cash flows?
Why do we need to calculate nominal cash flows and then deflate the nominal cash flows by the general inflation rate to get real cash flows?
And is deflated value has the same meaning as present value?
The problem is that the inflation rates applicable to the individual flows is not the same as the general rate of inflation (and would not be the same in real-life either).
Discounting the flows without inflation at the real cost of capital will only ‘work’ if the flows were inflating at the general rate of inflation, as I explain in my free lectures.The cash flows at current prices and the real cash flows are both the cash flows in the absence of inflation.
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