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The following question is from the BPP kit question 109
NCW Co is considering investing $10,000 immediately in a 1 year project with the following cash flows.
Income $100,000
Expenses $35,000The cash flows will arise at the end of the year. The above are stated in current terms. Income is subject to 10% inflation; expenses will not vary. 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 net present value of the project?A $68,175
B $60,190
C $58,175
D $78,175
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with multiple elements to put into consideration, I lost track and wasn’t able to join the dots from the solution provided. Help please.Have you watched my free lectures on investment appraisal with inflation?
Using the fisher formula on the formula sheet, the nominal (actual) cost of capital is (1.08 x 1.02) – 1 = 0.1016 (or 10.16% which is 10% to the nearest whole %)
The nominal cash inflow is 100,000 x 1.1 = 110,000. So the net cash inflow in 1 years time = 110,000 – 35,000 = 75,000
The PV at 10% = 75,000 x 0.909 = 68,175
Therefore the NPV = 68,175 – 10,000 = 58,175
Hi sir, may I know for income inflation why don’t use the general inflation rate but using the nominal rate?I’m confusing on this part.
For my calculation?
Y0 -10000 1 -10000?PV?
Y1 ?100000×1.02?=102000 x 1/1.1=92727?PV?
Y1 -35000 1/1.1 -31819?PV?*NPV=50908
Can sir explain further for the rate use for inflation part?I know how to get 10% by using fisher formula, but this rate isn’t merely use as discount factor?
The question specifically says to use the money cost of capital (i.e. the nominal cost of capital).
As I explain in my free lectures, the nominal cost of capital depends on the general rate of inflation.
We normally discount the nominal flows at the nominal cost of capital anyway because usually different flows are inflating at different rates.
I do suggest that you watch my free lectures.
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