Hi, in the questions after the topic, the 1st one I don’t understand why you included the $10 for labor as relevant cost if they are already fully employed. In the lectures you didn’t include the $40000 labor costs as they were already employed.

This is actually revision from Paper PM relevant costing.

The labour cost will indeed be paid whether or not they do the new project. However, think about this: Suppose the selling price is $20, the labour is $4, and the other variable costs (materials and overheads) are $3. The contribution is therefore $13.

If the labour is moved to another job, then they will lose the revenue of $20. They will save the other variable costs of $3. The labour will still be paid. So they will lose 20 β 3 = $17, and this is the relevant cost. This is (and always is) the same as the contribution of $13 plus the labour of $4.

Thank you so much for your lecture. if we get the nominal rate is 13.3% we can use 13% df in the table, but what if its 13.78% can we use 14% or do we have to use fraction(1/1+r). Thank you.

1. Inflate the cash flows and you’d have to discount them at the actual/nominal cost of capital if you’re provided with it. If you aren’t, use the Fisher Formulae to determine the nominal cost of capital.

2. If you don’t inflate them, you’d have to discount them at the effective interest rate/ real cost of capital.

Hi john I’ve got the point that we would get the same NPV whether we discount real cash flows by the real cost of capital or the inflated cash flows by the inflated cost of capital, but in the example there is no scrap & tax savings, if there had been any of these in the question, then the NPV we would get by discounting at the real cost of capital would be higher than the NPV calculated using the nominal or inflated cost of capital. My question is that how will it affect our decision & should we discount the tax savings & scrap value at the rate of inflation, before including them in cash flows, while discounting at the real cost of capital(because both of them are future values), to get the same NPV?

Secondly, as you said that in theory, the change in inflation rate doesn’t makes a difference to our decision as the cost of capital will change accordingly, resulting in same npv, but you focused that it is only in theory, why not its always the case practically?

The answer to both your points is that discounting the real cash flows at the real cost of capital only ‘works’ if all of the cash flows are inflating at the same general rate of inflation.

In real life and in most exam questions, different cash flows are subject to different inflation rates and therefore we need to inflate the cash flows to get the actual/nominal cash flows and then discount at the actual/nominal cost of capital.

As in your example, a general rate of inflation is applied to all cash flows, for example: If there were tax payments & tax savings in the same question & we are required to calculate the NPV in real & nominal terms, in this case, applying tax rate on the real cash flows will result in lower tax payments than applying the tax rate on the nominal flows, but if we calculate tax savings due to capital allowances, they will be the same in both cases. My question is that why don’t we deflate the figures for tax savings, before including them in the calculation of NPV, using real rate? The reason i’m asking this, is that there is one such question in December 2013 exam.

The December 2013 question was a slightly silly question for the reasons you have stated. However the examiner did allow you to deflate the tax savings which is what effectively he did in the alternative approach that he showed in his answer.

It is 6 per unit certainly, but the net operating flow is 60,000 which is what I have in the lecture (as usual in the exam, and as I say in the lecture, all of the figures are in thousands).

Wonderful lecture Sir. Just a small observation. If you just calculate 1.05/1.15 you get 9.13%, rounded to 9%. Then you discount at 2.531 and the NPV is +31.86 which is much closer to the initial +32.

Please I don’t get the comments here or they are probably misleading. 1/1.0952=0.913075=91.3% and not 9.13%. I think its just mere coincidence because discounting 1000 at 9.52% (df =1/1.0952) is never the same as discounting the same thousand at 9.13% (df=1.0913). I hope am clear.

Hi Mr. Moffat, do we ever round down instead of up? For example, 9.52% becomes 10%, had it been 9.22 would it still round up to 10% or would we round down to 9%?

what will happen to the cash flows if they are different in each of the five years and these cash flows are before taken account of general inflation. eg yr 1=10000, yr2=15000, yr 3 17000 and so on. inflation is at the rate of 6.2%. Thanks

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brian says

Hi, in the questions after the topic, the 1st one I don’t understand why you included the $10 for labor as relevant cost if they are already fully employed. In the lectures you didn’t include the $40000 labor costs as they were already employed.

John Moffat says

This is actually revision from Paper PM relevant costing.

The labour cost will indeed be paid whether or not they do the new project. However, think about this:

Suppose the selling price is $20, the labour is $4, and the other variable costs (materials and overheads) are $3. The contribution is therefore $13.

If the labour is moved to another job, then they will lose the revenue of $20. They will save the other variable costs of $3. The labour will still be paid. So they will lose 20 β 3 = $17, and this is the relevant cost. This is (and always is) the same as the contribution of $13 plus the labour of $4.

natty2 says

hi john why used discount factor formula because of the real cost of capital

John Moffat says

Because the tables do not have the factor for 9.52%

However, as I explain in the lecture, in the exam using the real rate is normally only relevant when it is a perpetuity.

natty2 says

thank you understand clearly

John Moffat says

You are welcome π

Sun says

Hi Sir,

What’s the difference between Actual Cost of Capital and the real cost of Capital?

In what kinds of situation, we have to use Fisher Formula?

Thanks

John Moffat says

I explain this completely in this lecture!!!!

ammu88 says

Thank you so much for your lecture. if we get the nominal rate is 13.3% we can use 13% df in the table, but what if its 13.78% can we use 14% or do we have to use fraction(1/1+r).

Thank you.

John Moffat says

You use 14% – the nearest whole %

rishabbohra98 says

Sir adding on to the question above, instead of taking the nearest whole at 14%, can we use (1/1+r) for D/F of 13.78%

John Moffat says

Of course you can, but it would be a rather silly thing to do since it takes more time and is not required of you.

leslie777 says

Hey John,

Great lectures! you are wonderful!

But where to find the article mentioned in notes? Its about advanced investment appraisal.

Thanks!

mystified says

Hi, you can find it on the accaglobal.com among technical articles.

mjibola says

1. Inflate the cash flows and you’d have to discount them at the actual/nominal cost of capital if you’re provided with it. If you aren’t, use the Fisher Formulae to determine the nominal cost of capital.

2. If you don’t inflate them, you’d have to discount them at the effective interest rate/ real cost of capital.

Understood!

John Moffat says

Precisely!

zee says

Thanks Super man…:) all your F9 lectures are so wonderful to brushup the basics for P4 exams.God bless you

John Moffat says

Thank you for the comment π

Mahrukh says

Hi john

I’ve got the point that we would get the same NPV whether we discount real cash flows by the real cost of capital or the inflated cash flows by the inflated cost of capital, but in the example there is no scrap & tax savings, if there had been any of these in the question, then the NPV we would get by discounting at the real cost of capital would be higher than the NPV calculated using the nominal or inflated cost of capital.

My question is that how will it affect our decision & should we discount the tax savings & scrap value at the rate of inflation, before including them in cash flows, while discounting at the real cost of capital(because both of them are future values), to get the same NPV?

Secondly, as you said that in theory, the change in inflation rate doesn’t makes a difference to our decision as the cost of capital will change accordingly, resulting in same npv, but you focused that it is only in theory, why not its always the case

practically?

John Moffat says

The answer to both your points is that discounting the real cash flows at the real cost of capital only ‘works’ if all of the cash flows are inflating at the same general rate of inflation.

In real life and in most exam questions, different cash flows are subject to different inflation rates and therefore we need to inflate the cash flows to get the actual/nominal cash flows and then discount at the actual/nominal cost of capital.

Mahrukh says

As in your example, a general rate of inflation is applied to all cash flows, for example:

If there were tax payments & tax savings in the same question & we are required to calculate the NPV in real & nominal terms, in this case, applying tax rate on the real cash flows will result in lower tax payments than applying the tax rate on the nominal flows, but if we calculate tax savings due to capital allowances, they will be the same in both cases.

My question is that why don’t we deflate the figures for tax savings, before including them in the calculation of NPV, using real rate?

The reason i’m asking this, is that there is one such question in December 2013 exam.

John Moffat says

The December 2013 question was a slightly silly question for the reasons you have stated. However the examiner did allow you to deflate the tax savings which is what effectively he did in the alternative approach that he showed in his answer.

Mahrukh says

Thanks π

John Moffat says

You are welcome π

Arun says

In the alternative method isn’t the net operating flow 6 (20-16) instead of 60?

John Moffat says

No – it is 200 – 140 = 60

Arun says

I looked at the solution in the notes and it’s taken as 60,000 which means the net operating flow is 6 per unit (60000/10000).

Thanks.

John Moffat says

It is 6 per unit certainly, but the net operating flow is 60,000 which is what I have in the lecture (as usual in the exam, and as I say in the lecture, all of the figures are in thousands).

Kelly says

Wonderful lecture Sir. Just a small observation. If you just calculate 1.05/1.15 you get 9.13%, rounded to 9%. Then you discount at 2.531 and the NPV is +31.86 which is much closer to the initial +32.

Kelly says

Never mind. its clarified when we use the fomula

annonymous says

Hi John.

Regarding the above comment, is it not better to discount at 9% rather than 10% if you do not wish to use the Fisher formula?

1/1.0952 = 9.13 rounded to 9% DOES give a more accurate answer than 9.52 rounded to 10%

And if i’m correct, can the same logic be used for other questions, or was this just a coincidence?

Thanks for the wonderful lectures…they have been very helpful π

John Moffat says

Its not a coincidence (and thanks for the comment) π

Ernest says

Please I don’t get the comments here or they are probably misleading. 1/1.0952=0.913075=91.3% and not 9.13%. I think its just mere coincidence because discounting 1000 at 9.52% (df =1/1.0952) is never the same as discounting the same thousand at 9.13% (df=1.0913). I hope am clear.

John Moffat says

Sorry – I misread the earlier comment. You are correct π

Ernest says

Thank you.

ahlaamzk says

Hi Mr. Moffat, do we ever round down instead of up? For example, 9.52% becomes 10%, had it been 9.22 would it still round up to 10% or would we round down to 9%?

John Moffat says

You round to the nearest – so 9.22 would be rounded to 9%

rabiatu says

what will happen to the cash flows if they are different in each of the five years and these cash flows are before taken account of general inflation.

eg yr 1=10000, yr2=15000, yr 3 17000 and so on. inflation is at the rate of 6.2%.

Thanks

John Moffat says

You use the same logic.

The actual cash flow at time 1 is 10,000 x 1.062

The actual cash flow at time 2 is 15,000 x 1.062^2

The actual cash flow at time 3 is 17,000 x 1.062^3