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Hi John,
This question is from BPP practise question.
Sid Co is evaluating an investment using NPV. During the analysis it has been noted that there is only one rate of inflation (3%) that affects sales revenue and operating costs in the same way.
The rate of tax is 25%, and Co will benefit from tax saving due to capital allowance that result from the capital investment.
Co is all equity financed and its s/holders expect a return of 10%Which one of the following statement is true?
Correct answer: It will be more accurate to discount the money CF using the 10% COC
My question here is why the answer ” The COC will have to be adjusted to 6.8% before being used to discount the real cash flows” is incorrect?
It is really helpful if you could explain this, please.
Hi there, Thanks for your question.
Ok so firstly-Im thinking you are happy that you would discount this investment using the weighted average cost of capital (or COC as you call it here!) and if this all equity financed, then this is the 10% rate.
This is what you would use to discount cashflows which are stated in nominal ( sometimes known as money cash flows) + what we assume that most figures stated in the future will be… ie that they INCLUDE inflation ( therefore you discount them with the 10% COC as it stands).
However, if you are told that the future cashflows are in ‘today’s terms’ or are ‘real cashflows’ or at ‘current /yr0 prices’… then your COC needs to be adjusted to. EXCLUDE inflation…
You discount real cashflows using a ‘real rate’.
This should all be covered in John’s lectures.To find a real rate, we refer to the fisher equation
1+ m = (1+r)(1+h)
Sometimes different ‘letters’ can be used to depict this relationship but it basically states that
1 + money flow rate = (1+ Real rate)* (1+ inflat rate)
so if 10% is the money flow rate
and
3% is the inflation rateThen we can rearrange the equation to get the REAL cost of capital
1 + r = 1.1/1.03
=
1.06796 (deduct the +1)and we can see that the REAL cost of capital which we use to discount cashflows which exclude inflation is 6.8% approx
The only thing is, that I cant see anywhere in the question that you refer to,..to suggest that those are REAL cashflows.. so maybe that was referenced elsewhere/ or maybe BPP missed it out – which is causing you the confusion.
Anyway, hope this helps
Cath
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