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This article discusses the nominal terms and real terms approaches to investment appraisal using the net present value
method, and also considers the impact of taxation in the context of these approaches. This is an area of the syllabus where
mistakes are often made by unprepared candidates.
In order to maintain the purchasing power of future cash receipts, the cash received must be inflated. Using the earlier
example and maintaining the purchasing power of $100.00 gives:
The inflated values in this table are also called nominal values.
Forecast sales volume is 300,000 units per year, increasing by 50,000 units per year, and the investment project is expected
to last for four years.
Using year 2 inflated costs as an example, when performing these calculations in a spreadsheet the following methods can
be used
=3.15*1.04^2
=3.15*POWER(1.04,2)
There are other methods of calculating these figures and any approach which gives the correct figures will be given credit in
the exam.
$3,025,871
$3,026,455
Allowing for rounding, the nominal NPV and the real NPV are identical, as can be seen by conducting these calculations with
a spreadsheet.
The real after-tax cost of capital is related to the nominal after-tax cost of capital by the Fisher equation, so the real after-tax
cost of capital is approximately (1.0675/ 1.048) = 1.0186 or 1.86%
Discounting to find the real terms after-tax NPV:
$2,611,289
Once again, considering rounding, the nominal terms and real terms after-tax NPVs are the same.
$2,648,333
$2,648,376
Once again, considering rounding, the nominal terms and real terms after-tax NPVs are the same.
Conclusion
If care is taken to understand the differences between the nominal terms approach and the real terms approach to
investment appraisal, and if care is taken to understand the requirements of an exam question in the area of investment
appraisal that incorporates inflation and taxation, candidates are likely to do well in this part of the syllabus.
Written by a member of the Financial Management examining team