Deflating cash flows

Hello Mr Sir, Q 290 2022-2023 F9 Kaplan exam kit

In the following question for asking for the different approaches for dealing with inflation with cash flows in the model Answer they are talking about deflating the current cash flows to reach the real cash flows and then discounting with the real discount rate,

So it is a new thing about deflating.Do we have to deflate the cash flows or only have to ignore the inflation and the discount with real discount rate as you said in the lecture.

Can you clarify Sir,

Thanks,

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Q
In relation to investment decision 3, describe the two approaches for dealing with  inflation AND provide a reasoned recommendation as to which approach Crocket’s  management should follow. ?

Answer
When appraising an investment, the treatment of inflation needs to be considered as  it will affect both cash flows and the required rate of return used as the discount rate.  Real?terms and nominal?terms approaches to investment appraisal differ in the way  that the effects of inflation are incorporated into the appraisal calculation. 

Nominal?terms approach  With the nominal?terms approach (also known as the money method), both the cash  flows and the discount rate incorporate the effects of inflation. The cost of capital  would also need to include the effects of general inflation on the investors’ required  rate of return. This means Crocket Co will need to apply the specific rates of inflation  to sales, material costs and other cash flows and ensure the cash flows in the appraisal  incorporate these. The uncertainty surrounding the rates of inflation that Crocket Co  faces with this project will certainly make an appraisal in nominal?terms more difficult  to prepare with any accuracy and this should be considered when reviewing the  results.  Real?terms approach  A  real  terms  approach  would  exclude  the  effects  of  general  inflation.  Therefore,  nominal  cash  flows  incorporating  the  effects  of  specific  inflation  rates  would  be  deflated by the general rate of inflation to give real?terms cash flows. The discount  rate will also exclude the effects of inflation. Consequently, a real discount rate would  be used which represents the investors’ base level of return for risk before inflation is  taken into account.