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why is the inflation rate used if the cashflows were discounted using a nominal rate,
Example 1
A company is appraising a three-year project which requires an initial outlay on 1 January 20X4 of $30,000. The project is expected to give the following cash inflows on 31 December of each year: 20X4 $10,000
20X5 $20,000
20X6 $25,000
All of the above cash flows are before taking account of specific annual inflation of 5% per year. The real cost of capital is 4% and the nominal cost of capital is 14%. Using a nominal approach and the discount tables provided, what is the NPV of the project on 1 January 20X4 (to the nearest dollar)?
The correct answer is $15,701
Yr 1 PV = 10,000x 1.05 x 0.877 = $9,209 Yr 2 PV = 20,000×1.05^2×0.769 =$16,957 Yr 3 PV = 25,000×1.05^3×0.675 =$19,535 NPV =9,209+16,957+19,535-30,000 =$15,701
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