Discounted Cash Flow Analysis

Hi Sir

I attempted a past question (Dec 2013, Darn Co) and because the scenario advised that prices and costs were rising by the general rate of inflation, I thought there would be no point inflating by the general rate and then using the nominal cost of capital and then discounting back to PV because I thought I could achieve the same result, by keeping the real cash flows provided and using the real cost of capital (by dividing ‘1+nominal cost of capital’ by ‘1+inflation rate’), but this didn’t work and I can’t figure out why!

I later saw that the question instructed that the nominal terms approach should be used, does that mean even when there is only a general inflation rate of price and cost increase, that we have to still perform the calculation by inflating at the general rate to get the nominal cash flows?

In another question (June 2011, BRT Co) the mark scheme/examiner’s commented that some students adopted a real terms approach and went on to say that this ‘was not correct in this case because profit was taxable one year in arrears’! Does this mean that, even if we’re NOT told to use a nominal approach, and the only inflation rate provided, is the general rate of inflation, we would still have to adopt the nominal terms approach, whenever tax payments/savings are one year in arrears i.e. regardless of whether prices and costs are inflating by the general rate of inflation only, if tax is paid in arrears, you have to use the nominal approach?

Thank you,

Ali