- May 8, 2021 at 1:18 am #619993
Sir, I am having a problem understanding the question called Pinks Co requirement a(ii) where it is asked to “calculate the real net present value of Pinks Co’s investment project”.
Since, we have been given both general inflation & specific inflation in the question & I know that real cashflows do not take inflation into account, so can we calculate the real cashflows before tax without any inflation (for sales, variable cost & fixed cost)?
I know how the examiner has calculated real cashflow before tax from taking nominal cashflow before tax from [part a (i)] by deflating them to the general rate of inflation [but I can’t understand why do we first calculated every cashflow before tax with specific inflation & then deflating them with the general rate of inflation]
Can you please tell me that how do we calculate the cashflow before tax such as Sales, Variable cost & Fixed cost to get to the real cashflow before tax?May 8, 2021 at 8:55 am #620018
In future please do state which exam the question was in – I cannot remember the name of every question that has ever been set.
However, I have managed to find this question. 🙂
It was actually a rather silly exercise for the examiner to ask, but he has done it twice and might do it again.
You are happy calculating the nominal cash flows and then discounting them at the nominal WACC in part (a)(i) of the question. Usually that is all that is relevant.
For part (a)(ii), to get the real cash flows, we take the actual/nominal flows from part (i) and ‘remove’ the general rate of inflation.
So, at time 1, the nominal cash flow before tax is 14,148 (from part (i)). The general rate of inflation is 3.7%, and therefore the real cash flow is 14,148 / 1.037 = 13,643.
At time 2, the nominal cash flow is 24,097. So the real cash flow is 24,097 / (1.037^2) = 22,408.
It is the same logic for time 3 and 4 cash flows.May 8, 2021 at 11:19 am #620041
Sir, I understand your calculation BUT I couldn’t grasp the logical explanation behind why do we first inflate all the things such as Sales, variable cost & fixed cost at their specific rate of inflation as we normally do and then remove the general rate of inflation to get real cashflows because the cashflows were inflated at a specific rate, not on the general rate.
Are you saying that since general inflation is overall inflation in the economy & when we calculated nominal cashflow before tax (in part a) has also the incorporation of general inflation even though we never used that rate of general inflation?
[Can you please explain why this happen? why do we remove general inflation? even though we did not incorporate general inflation in any of the calculation done (in part a of the question)]
I was trying to calculate all cashflows before tax without any inflation to be taken for sales, variable cost & fixed cost because to calculate real cashflows we don’t take inflation (Is that right?)
Isn’t there a way where we can calculate things such as Sales, Variable cost & Fixed cost in any other way except what u mentioned above?
Thanks for your time!May 8, 2021 at 3:47 pm #620064
The general rate of inflation is the overall inflation rate in the economy. Individual costs and the revenues will inflate at different rates, just as they do in real life.
The WACC will be higher or lower as the general rate of inflation is higher or lower, and as I illustrate in my lectures, we can either discount the actual cash flows at the actual cost of capital, or, alternatively we can discount the real cash flows at the real cost of capital (and end up with the same result). However, just as to get the real cost of capital we remove the general rate of inflation, to get the real cash flows we need to remove the general rate of inflation from the actual cash flows.
There is no other way of doing it (and we only do this if the question specifically asks us to do it).May 8, 2021 at 10:19 pm #620094
Thank you! I understood your answer. Can you please help me here, I am a little confused.
In (Chapter 8 – example 6 (b)) you have discounted real cashflows with the real cost of capital without taking inflation into account. Since you haven’t used inflation here so I was saying is that possible that we can leave the cashflows as it is without inflating them (in Pinks Co question) & then discount them at real cost of capital? [as I have done in my answer below – please correct me there]
[My Answer – Pink Co]
Year 1 Calculations:
Sales—————-(300,000 x 125) = 37.5m
Variable cost——-(300,000 x 71) = (21.3m)
Fixed cost—————————— = (3m)
Real cashflow before tax ———- = 13.2m
Taxation ——————————– = (3,547m)
Capital Allowance ——————– = 1.3m
Cash flows after tax —————— = 10.953m
Discount Factor 8% —————— = 0·926
PV —————————————- = 10.142m
I did the Year 1 calculation only I hope the rest yearly calculations will be same like this. I know it becomes a lengthy calculation doing this way but I did this to know whether is this also the correct way which is quite understandable to me if correct? What do u say?May 9, 2021 at 9:26 am #620121
No, you cannot do it that way.
That would only work if everything was inflating at the same general rate of inflation.
If different items are inflating at different rates then there is no choice but to do as in Pink. i.e. calculate the actual cash flows, inflating at the relevant inflation rates, and then removing the general rate of inflation to get the real cash flows. Then we can discount at the real cost of capital.
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