Pinks Co

You would not lose all of the marks but you would lose some. The reason is that the flows are inflating at different rates that the general inflation rate.

I'm actually trying to understand Pinks Co. Question 32 a part (ii) of this question. Please explain how they arrive at the real cash flows before tax. I thought the real cash flows were simply using the forecasted data given without adjusting for inflation. I am looking at the answer, but not understanding how they arrived at the following real cash flows before tax. Y1 $13,643, Y2 $22408, Y3 $35,823, Y4 $8,975 Please explain

The nominal cash flow at time 1 is 14,148. The general rate of inflation is 3.7%. Therefore the real cash flow = 14,148 / 1.037 = $13,643 The nominal cash flow at time 2 is 24,097 Therefore the real cash flow (removing two years inflation) is 24,097 / (1.037^2) = $22,408 It is the same logic for the other two :-)

what's the logic behind deflating when we have real values and real discount rate? why need to deflate the nominal values?

The 'real' cash flows are the nominal cash flows with the general rate of inflation removed. The 'real' cost of capital is the nominal cost of capital with the inflation removed. It is actually a rather silly exercise for the examiner to ask, but he has done so twice. I do explain the relationship between the real and nominal cash flows and the real and nominal cost of capital in my free lectures.

I agree John, the whole structure of this part of the question is pretty silly imo. Wouldn't it make more sense to aggregate the after tax cash flows into one line and then deflate that at 3.7%? I understand that tax itself is not inflated, but it is taken on operating cash flows that are, so in effect it is and should be subject to the same deflation calculation. In fact, considering tax is calculated on inflated cash flows it is in effect inflated so by NOT deflating the savings from tax allowable depreciation we're then creating a mismatch of inflated and non inflated values. What on earth is the point? Assuming we would lose marks if we were to just deflate the after tax cashflows we're actually being penalized for doing it the correct way, and what we're expected to do is guess which wrong method the examiner has used, which is absurd. Please let me know if I have misunderstood this.

What is the question asking for? It is a rather odd thing for them to ask, we agree with you! You have to display your knowledge of understanding of the question requirements and what to do. That is why in almost all questions we simply discount the nominal flows at the nominal cost of capital. We only deflate and use the real cost of capital if the question specifically asks for it. The 'real' cash flows are derived by deflating nominal cash flows, including working capital, at the general rate of inflation. It is also worth noting that tax is applied to inflated cash flows, which can create a mismatch if not handled correctly. The safest approach in exams is to deflate the net cash flows (after tax) to ensure consistency. If the examiner's method appears to create confusion for you state any assumptions you make in your answer. By clearly stating your assumptions and adhering to the standard practice of deflating net cash flows, you can present a well-reasoned answer that demonstrates your understanding of these principles. You do whatever you feel is right, you will still get marks.