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Hello! sir I am very confused with the requirement (ii) Calculate the real net present value of Pinks Co’s investment project and comment on your findings.
I saw your lecture on investment appraisal and you yourself said that the only time discounting cashflows at real cost of capital is valid is when the costs and revenue both are inflating at the general rate of inflation, I am misquoting but it was something similar to this. But in this question the revenue, variable costs and fixed costs all have a specific rate of inflation then how we can calculate the Real NPV when they are not inflating at the general rate of inflation.
I also looked at the study text in the study hub they also had a similar line saying
“The only situation in which the real method is valid is when revenues and costs all increase at the general inflation rate. In this case cash flows before inflation can be discounted at the real cost of capital”
am I not understanding this correctly? Can you please explain. Thank uAlso, sir there is another question I just read the article of acca on the Inflation and investment appraisal in the article there were different scenarios they delt with first without taxation they first deflated the nominal contribution by the general rate of inflation and then discounted at the real cost of capital to calculate real NPV
in the next section where taxation was involved, they deflated the after tax cashflows by the general rate of inflation and then discounted it at the real cost of capital.
So, my question is in the Kaplan kit they deflated the before tax cashflows and then deducted tax and added tax saving why they also didn’t do the same thing what was done in the ACCA article to deflate the after-tax cash flows and then discount them at the real cost of capitalIdentify real cflows
Since the revenues, variable costs, and fixed costs have specific rates of inflation, you need to adjust these cash flows to remove the effect of inflation. This means you should deflate the nominal cash flows by the specific inflation rates to get the real cash flows.Discount the real cflows
Once you have the real cash flows, you discount them using the real cost of capital. The real cost of capital is derived by removing the general inflation rate from the nominal cost of capital.Then calc the real NPV as the sum of the the present values of the real cash flows to get the real NPV.
Regarding your confusion about the general rate of inflation, the key point is that the real method is valid when all cash flows (revenues and costs) are adjusted for their specific inflation rates and then discounted at the real cost of capital. This ensures that the inflation effects are consistently removed from both the cash flows and the discount rate.
In summary, even if the revenues and costs have specific inflation rates, you can still calculate the real NPV by deflating the nominal cash flows by their respective inflation rates and then discounting these real cash flows at the real cost of capital as per the article and text book.
Sir that is exactly what i did in the question i deflated the cash flows by their respective inflation rates and then discounted at the real cost of capital but i got a completely different awnser the reason being in the kit they took the nominal before tax cash flows (so these are inflated by their respective inflation rates) and then deflated the before tax cashflows at the general rate and then deducted the tax effects and discounted at the real cost of capital to get the real NPV.
But pinks asks you to (i) calculate using a nominal terms
and (ii) using a real terms?In theory, both methods should give near enough the same result because inflation rates and interest rates are assumed to move together. However, this only holds true if everything inflates at the same rate.
For Pinks Co:
Nominal NPV Calculation: Use the nominal cash flows and discount them using the nominal cost of capital. 12%
Real NPV Calculation: Use the real cash flows (excluding inflation) and discount them using the real cost of capital. 8%
This distinction is crucial in investment appraisal to understand the impact of inflation on the project’s value.
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