Money rate vs real rate confusion

Hi Cath

I was doing a question and came across something I just wanted you to clarify..

P Ltd intends to purchase a machine that will cost 18,000. the machine will save operating cost of 12,000 in the first year. Operating cost are budgeted to increase in year 1 by 8%/ Both the annual average rate of inflation and the real cost of capital are 10%. The machine has a 2 year life with a salvage value receivable at the end of the year 3 of 3,000. What is the NPV of the proposed investment

Solution…

Year Cash flows DF ( 21%)
0 (18,000) 1
1 (12,000) ……
2 (12960)(adjusted for increase in expenses- 8%) ……..
2( scrap) (3000) ….

Now- initially I struggled to get the DF to be 21%. I initially thought it was 10% and then I peaked at the answers and say that the DF was 1.1%*1.1% and then wondered why..

I know that that the money rate should be applied to inflated value when trying to determine the NPV.

(1 +money rate)- (1+real rate)* (1+inflation rate)

which explains the (1.1% *1.1%)= 1.21% where 21% equals the money rate…my question is how do you know when to apply the money rate or the real discount rate? My book says the money rate is used when inflation occurs and real rate is when there is no inflation.. but why? whats the theory behind it… the reason..

Thanks from Abi