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Hi sir,
In the Sept 15 examiner’s report,for Q5b,the examiner wrote that real term & nominal approach includes ‘inflation’ but in different ways.Why is it,should’nt it be real approach ignores inflation?
And what does it mean by ““nominal cash flows which have been calculated by applying specific inflation to current price terms estimates can be turned into real cash flows by
deflating them by the general rate of inflation”?Thank you.We either include inflation in the cash flows to get the nominal cash flows and then discount at the actual cost of capital; or alternatively we do not include the inflation in the cash flows (so use the real cash flows) but remove the inflation from the cost of capital and therefore discount at the real cost of capital.
So what the examiner is meaning is that using the real cash flows is not ignoring inflation completely because we have to remove it from the actual cost of capital.
If you are given the current price (real) cash flows then we inflate them to get the nominal (actual) cash flows.
On the other hand, if we were given the nominal (actual) cash flows, but wanted the real cash flows, then we would need to take out the inflation from the cash flows (i.e. deflate them).I am bit confused about the real and nominal term.
If the price/ cost are given in nominal term, when we calculate the nominal cash flow, we don’t need to inflate them? Am i wrong?
What’s the difference between the price given in “current price term” and ” Nominal term”?Nominal cash flows are actual cash flows. If you are given the actual cash flows then you do not need to inflate them. If you are given the cash flows at current prices then you do need to inflate them to get the nominal cash flows.
The nominal cash flows are discounted at the nominal (actual) cost of capital.Real cash flows are the cash flows ignoring inflation (i.e. at current prices). Either we discount the real cash flows at the real cost of capital (i.e. the cost of capital without inflation), or – more usually – we inflate them to get the nominal cash flows and then discount at the nominal cost of capital.
Have you not watched my free lectures on this? 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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