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Inflation

Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › Inflation

  • This topic has 1 reply, 2 voices, and was last updated 1 year ago by LMR1006.
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  • April 21, 2024 at 10:02 am #704371
    Simone
    Participant
    • Topics: 12
    • Replies: 33
    • ☆

    I am trying to understand illustration 2 on page 144 of the BPP P&R – looking at the deflated cashflows. In summary:

    The cost of purchasing a machine is $10m, running costs are $1.2m/yr and the savings in rental costs are $6.6m
    Running costs increase at a general inflation rate of 5.26% and rental costs being saved are expected to increase at 2%/yr. The real cost of capital is 14%.

    Where the example says “Deflated / 1.0526)^n” What exactly is the “Deflated” figure that is being divided by 1.0526 to get 0.95 in year 1?

    Earlier in the chapter, it states that the deflated rate is (1+r)=(1+i)/(1+h)^n, therefore 1+r = (1+0.2)/(1.0526) = 1.14
    Then discount the real cashflows at the real cost of capital – so 14% at time 1 = 0.877 not 0.95.

    April 21, 2024 at 1:33 pm #704376
    LMR1006
    Keymaster
    • Topics: 4
    • Replies: 1511
    • ☆☆☆☆☆

    The deflated figure in the example refers to the nominal cash flow divided by the deflation factor. The deflation factor is calculated as (1 + r) = (1 + i) / (1 + h)^n, where r is the real rate of interest, i is the nominal rate of interest, and h is the rate of inflation. In this case, the deflated figure is obtained by dividing the nominal cash flow by (1.0526)^n

    In the example you mentioned, the deflated figure in year 1 is obtained by dividing the nominal cash flow by (1 + 5.26%)^1, which gives 0.95.
    This adjustment accounts for the increase in general inflation over time. The deflated figure refers to the nominal cash flow adjusted for inflation.

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