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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 a business environment with inflation, future cash flows will have decreasing
purchasing power in current value terms as time passes. For example, if inflation is
expected to be 5% per year and a cash amount of $100.00 is received at the end of each
year for three years, the deflated values of these future cash receipts are as follows:
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.
It is important to grasp the difference between general inflation and specific inflation.
General inflation is measured by a published measure, such as the eurozone Harmonised
Index of Consumer Prices (HICP). Specific inflation means that specific project variables
such as selling price, variable costs and fixed costs inflate at different rates, such as 5%
for selling price, 4% for variable costs and 6% for fixed costs.
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The real cost of capital (r) and the nominal cost of capital (i) are related by general
inflation (h) in the Fisher formula, provided in the examination formulae sheet:
(1 + i) = (1 + r)(1 + h)
If the real cost of capital is 4.0% and the general rate of inflation is 4.8%, the nominal cost
of capital is 9.0%:
Since costs of capital are normally given in nominal terms, it is more usual to calculate
the real cost of capital by deflating the nominal cost of capital by the general rate of
inflation:
Nominal cash flows are current price terms cash flows that have been inflated into future
values, as illustrated above, using either general or specific inflation.
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.
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Inflated variable costs
Year 1: 3.15 x 1.04 = $3.28 per unit
Year 2: 3.15 x 1.042 = $3.41 per unit
Year 3: 3.15 x 1.043 = $3.54 per unit
Year 4: 3.15 x 1.044 = $3.69 per unit
=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.
Real cash flows are found by deflating nominal cash flows by the general rate of inflation.
The nominal terms approach to investment appraisal involves discounting nominal cash
flows with a nominal cost of capital in calculating the NPV of an investment project.
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Year 1: 687,000/ 1.09 = $630,275
$3,025,871
The real terms approach to investment appraisal involves discounting real cash flows with
a real cost of capital in calculating the NPV of an investment project.
$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.
What is the effect on the NPV calculations of including taxation? Assume corporation tax
of 25% and straight-line tax-allowable depreciation (TAD) over four years with zero
residual value.
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Nominal terms after-tax cash flows
Year 1: 687,000 – (687,000 x 0.25) + 62,500 = $577,750
Year 2: 850,500 – (850,500 x 0.25) + 62,500 = $700,375
Year 3: 1,040,000 – (1,040,000 x 0.25) + 62,500 = $842,500
Year 4: 1,237,500 – (1,237,500 x 0.25) + 62,500 = $990,625
$2,611,243
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%
$2,611,289
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Once again, considering rounding, the nominal terms and real terms after-tax NPVs are
the same.
$2,648,333
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Year 3: 773,117/ 1.01863 = $731,534
$2,648,376
Once again, considering rounding, the nominal terms and real terms after-tax NPVs are
the same.
If an exam question contains specific inflation rates and also provides a general rate of
inflation, the nominal terms approach is quicker and is recommended, since nominal cash
flows must be calculated using specific inflation before deflating these by the general rate
of inflation to give real cash flows for use in a real terms approach. Note that if a real
terms approach is adopted, the specific inflation rates cannot be ignored.
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.
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