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I am having a problem with this question.
An investment of $400,000 in new ticket machines. Net cash savings of $120,000 per year are expected in current price terms and these are expected to increase by 3.6% per year due to inflation during the 5-year life of the machines.
Basril Co has a money cost of capital of 12% and taxation should be ignored.
As how I understand this, the money cost of capital already includes the inflation, right? However, in the answer, they still inflate the net cash savings each year before multiplying them with the 12% discount factor.
I do not understand this part.
Please help me with this.
Unless the question specifies otherwise, we always discount the nominal/actual cash flows (i.e. as inflated) at the nominal/actual/money cost of capital. This is what has been done here – the flows have been inflated and they are discounted at the actual cost of capital of 12%.
(The alternative – which is less often required – would be to discount the current price flows (i.e. without inflation) at the real cost of capital (which is the money cost of capital with the inflation removed. The end result would be the same.).
I explain all of this in my free lectures on investment appraisal with inflation. The lectures are a complete free course for Paper FM and cover everything needed to pass the exam well.