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Hello
i am looking at a question here , that says “income is subject to 10% inflation. the real cost of capital is 8% and general inflation is 2%. using the money cost of capital to the nearest whole % what is the NPV of the project?what i dont understand:
1-i know that , 1+nominal= (1+inflation) x (1+real)
but in the answer they try to find real rate using 1+nominal as 1.102. i dont understand why it is 1.1022- from reading the text book, the nominal rate incorporates inflation therefore i think the nominal rate should be 1 +0.10=1.10
3-if the nominal rate incorporates inflation then what is 1+inflation? wouldnt it be the same?
another question regarding inflation……
if a co is expecting a tax $10,000 (in real terms) in one years time and inflation is expected to increase, why will the impact be nil on the present value of the receipt?im thinking it because even though the 10,000 will increase, everything else would increase as well so the purchasing power would still be $10,000 worth thereby having a nil effect. Is that correct?
Effectively you are correct.
The actual cash flow will be higher (due to the inflation). But also, higher inflation will mean a higher cost of capital as well.
So in theory, it should make no difference at all. (In practice things do not work perfectly and we cannot just ignore inflation 🙂 )
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