The two rates of return and the inflation rate are linked by the equation 1 i 1

The two rates of return and the inflation rate are

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The two rates of return and the inflation rate are linked by the equation, (1 + i) = (1 + r)(1 + h) where all rates are expressed as proportions. (1 + 0.2) = (1 + r)(1 + 0.1) 1 + r = 1.2 / 1.1 = 1.091 r= 9.1% Part 2: Do we use the real rate or the nominal rate? The rule is as follows. (a) If the cash flows are expressed in terms of the actual number of dollars that will be received or paid on the various future dates , we use the nominal rate for discounting . (b) If the cash flows are expressed in terms of the value of the dollar at time 0 (that is, in constant price level terms), we use the real rate .
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___________________________________________________________________________________________________________________ Page 3 of 13 IPK COLLEGE 1664, JALAN KULIM, 14202 BUKIT MERTAJAM, PENANG TEL : 012-5203212 / 0125113212 / 04-5512588 Subject: Financial Management (DFM1) Prepared by Susan Lim Email : [email protected] The cash flows given above are expressed in terms of the actual number of dollars that will be received or paid at the relevant dates (nominal cash flows). We should, therefore, discount them using the nominal rate of return. Time Cash flow ($) Discount factor 20% PV ($) 0 (15,000) 1 9,000 2 8,000 3 7,000 The project has a positive net present value of $_______. The future cash flows can be expressed in terms of the value of the dollar at time 0 as follows, given inflation at 10% a year. Time Cash flow ($) Cash flow at time 0 price level 0 (15,000) 1 9,000 2 8,000 3 7,000 The cash flows expressed in terms of the value of the dollar at time 0 (real cash flows) can now be discounted using the real rate of 9.1%. Time Cash flow ($) Discount factor 9.1% PV ($) 0 (15,000) 1 9,000 2 8,000 3 7,000
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___________________________________________________________________________________________________________________ Page 4 of 13 IPK COLLEGE 1664, JALAN KULIM, 14202 BUKIT MERTAJAM, PENANG TEL : 012-5203212 / 0125113212 / 04-5512588 Subject: Financial Management (DFM1) Prepared by Susan Lim Email : [email protected] Part 3: The advantages and misuses of real values and a real rate of return (1) Generally the companies should discount money values at the nominal cost of capital, there are some advantages of using real values discounted at a real cost of capital. (a) When all costs and benefits rise at the same rate of price inflation, real values are the same as current day values , so that no further adjustments need be made to cash flows before discounting. In contrast, when nominal values are discounted at the nominal cost of capital, the prices in future years must be calculated before discounting can begin. (b) The government might prefer to set a real return as a target for investments, as being more suitable than a commercial money rate of return. Cost and benefits which inflate at different rates (1) Not all costs and benefits will rise in line with the general level of inflation. In such cases, we can apply the nominal rate to inflated values to determine a project's NPV . Example: Inflation Rice is considering a project which would cost $5,000 now. The annual benefits, for four years, would be a fixed income of $2,500 a year, plus other savings of $500 a year in year 1, rising by 5% each year because of inflation. Running costs will be $1,000 in the first year, but would increase at 10% each year because of inflating labour costs. The general rate of inflation is expected to be 7½% and the company's required nominal rate of return is 16%. Is the project
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  • Spring '17
  • JANE KDAL

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