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

• 13

This preview shows page 2 - 5 out of 13 pages.

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 . Subscribe to view the full document.

___________________________________________________________________________________________________________________ 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 ___________________________________________________________________________________________________________________ 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 Subscribe to view the full document. • Spring '17
• JANE KDAL

### What students are saying

• As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

Kiran Temple University Fox School of Business ‘17, Course Hero Intern

• I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

Dana University of Pennsylvania ‘17, Course Hero Intern

• The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

Jill Tulane University ‘16, Course Hero Intern