considering Inflation with NPV — OpenTuition Forums

SSoyut7y ago

Hi, I am a newbie here. I am having difficult time to understand the calculating NPV when inflation rate is considered. To make it simple, i give this example Initial investment is $1000 Net Cash flows for 4 years are as below; year 1: 200 year 2: 300 year 3: 300 year 4: 300 Discount rate (interest rate for each year) is : 4% Inflation rate (assuming it is going to be same for every year) is : 4.5% Here is the trick part, I know if the inflation rate is higher than the discount rate, it is not profitable at all, but how we put it into calculation ? what is NPV for this investment if we use inflation 4.5% and if we use 3.5%? Thanks in advance. Kind Regards

CChris7y ago#1

You multiply the cashflow for each year by the inflation rate ^ t. Year 1: $200 * 1.045 = $209 Year 2: $300 * 1.045^2 = $327.61 Then you discount the cashflows using the discount rate, and add them all together (including the initial investment as a negative) to get the NPV. You can look up the discount factor in the table, or calculate it as follows: Year 1 = $209 *1/1.04 = $200.96 Year 2 = $327.61 * 1/1.04^2 = $302.89 Using this you should be able to calculate the NPV.

SSoyut7y ago#2

Thanks for the answer. Is there any way of doing it using only one formula?

SSoyut7y ago#3

Also, why we multiply cash flow with inflation rate? I don't get the point of doing it. Doesn't inflation decrease the value of money ?

John MoffatTutor7y ago#4

Soyut: Why on earth do you write that 'because the inflation rate is higher than the discount rate, it is not profitable'? That is simply not true (and not only because of the fact that profits have nothing at all to do with the decision making!). It will help you to watch my free lectures on investment appraisal with inflation. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.