Chapter-04 Investment Appraisal: Further aspects of discounted
cashflows
The impact of inflation on interest rates
Inflation is a general increase in prices leading to a general decline in the real
value of money. In times of inflation, the fund providers will require a return
made up of two elements:
1. Real return
2. Inflation
Therefore, the overall required return is called the money or nominal rate of
return.
Money or nominal rate of returns (1+i) = (1+r) * (1+h)
The impact of inflation on cash flows
➢ Where cash flows have not been increased for expected inflation, they are
described as being in current prices/today’s prices/real cash flows.
➢ Where cash flows have been increased to take account of expected
inflation they are known as money cash flows/nominal cash flows.
Methods of dealing with Inflation
Real Method Money/Nominal Method
1. Do not inflate the cash flows- leave 1. Inflate each cash flow by the
them in real terms i.e., prices- real inflation rate i.e., convert it to a
flows. money flow.
2. Discount using the real rate. 2. Discount using the money rate.
Specific and General Inflation Rates
Specific Inflation Rates General Inflation Rates
1. Impacts all the individual cash flow 1. Impacts the investor’s overall
items- each cash flow is affected by a required rate of returns.
specific rate. 2. Investors in the project need
compensation for their lost
purchasing power, which relates to
their ability to buy a basket of all
goods, rather than any specific one.
1
In situations where you are given a number of specific inflation rates, the real
method outline above cannot be used.
Impact of Corporation Tax
Tax charged on cash flows Tax relief on investment
1. Additional income = additional tax 1. Tax allowable depreciation allowed
paid as an expense.
2. Additional costs = less tax paid
Tax-allowable depreciation
➢ It is calculated based on the written down value of the assets.
➢ The total amount of tax-allowable depreciation given over the life of an
asset will equate to its fall in value over the period.
➢ It is claimed as early as possible.
➢ It is given for every year of ownership except the year of disposal.
➢ In the year of disposal or scrap, a balancing allowance or balancing charge
arises.
Incorporating Working Capital
Working capital refers to the amount of long-term funds used to finance the
short-term current asset investments. The treatment of working capital is as
follows:
➢ Initial investment of working capital is a cash outflow.
➢ If investment is increased during the project, the increase is a relevant
cash outflow.
➢ If investment is decreased during the project, the decrease is a relevant
cash inflow
➢ At the end of the project all the working capital is released and treated as
a cash inflow unless stated otherwise in the question.
To calculate the working capital cash flows, you should:
Step:1 Calculate the absolute amounts of working capital needed in each period.
Step:2 Work out the incremental cash flows required each year.
2
Dealing with questions with both tax and inflation
➢ Inflate costs and revenues, where necessary before determining their tax
implications.
➢ The cost and disposal values have to be inflated (if necessary) before
calculating tax-allowable depreciation.
➢ Always calculate working capital on these inflated figures, unless given
specifically mentioned in the question.
➢ Use a post-tax money discount rate.