# fm12 17 - with a real rate In theory you could do either...

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Mini Case: 12 - 17 c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows? Answer: With an inflation rate of 3%, the annual revenues and costs are: Year 1 Year 2 Year 3 Year 4 Units 1250 1250 1250 1250 Unit Price \$200.00 \$206.00 \$212.18 \$218.55 Unit Cost \$100.00 \$103.00 \$106.09 \$109.27 Sales \$250,000 \$257,500 \$265,225 \$273,188 Costs \$125,000 \$128,750 \$132,613 \$136,588 The cost of capital is a nominal cost; i.e., it includes a premium for inflation. In other words, it is larger than the real cost of capital. Similarly, nominal cash flows (those that are inflated) are larger than real cash flows. If you discount the low, real cash flows with the high, nominal rate, then the resulting NPV is too low. Therefore, you should always discount nominal cash flows with a nominal rate, and real cash flows
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Unformatted text preview: with a real rate. In theory, you could do either way and get the correct answer. However, there is no accurate way to convert a nominal cost of capital to a real cost. Therefore, you should inflate cash flows and then discount at the nominal rate. c. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows? Answer: With an inflation rate of 3%, the annual revenues and costs are: Here are the annual operating cash flows (in thousands of dollars): 1 2 3 4 Net Revenues \$125 \$125 \$125 \$125 Depreciation 79 108 36 17 Before-Tax Income \$ 46 \$ 17 \$ 89 \$108 Taxes (40%) 18 7 36 43 Net Income \$ 28 \$ 10 \$ 53 \$ 65 Plus Depreciation 79 108 36 17 Net Operating CF \$107 \$118 \$ 89 \$ 82...
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