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Hello Sir,
I am having some issues regarding which discount rate to use in some investment appraisal questions.
Suppose we are doing an appraisal to buy a new machine which will be purchased by borrowing money at interest cost 10% p.a
Revenue are expected to inflate at 5% p.a
Operating costs expected to inflate at 3% p.aTo get nominal cash flows, we inflate the revenue and costs with 5% and 3% respectively. (Right?)
When discounting, what rate is should be used? if we are provided with several rates, such as cost of capital, real cost of capital, after tax interest cost.
Thank you
You are right in what you say about the nominal cash flows.
Usually you discount the nominal cash flows at the nominal (actual) cost of capital.
The alternative is to discount the current price cash flows (ignoring inflation) at the real cost of capital. However you can only do this if all flows are inflating at the same rate of inflation, and is only relevant in the exam if either the question specifically asks you to do it that way, or if you are dealing with a perpetuity (which is rare in the exam).
All of this is explained in full (with examples) in my free lectures on relevant cash flows for investment appraisal. The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
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