Chapter # 01
Introduction to
Project Appraisal
DCF AND INFLATION:
Inflation should be incorporated in financial planning and decision making.
When a company makes a long-term investment, there will be costs and benefits for a number of years. In all
probability, the future cash flows will be affected by inflation in sales prices and inflation in costs. Inflation
increases the return on investments required by investors. In a world without inflation an investor might be
content with a 10% return on an investment. With inflation the investor knows that the purchasing power of
future cash flows received will be less due to inflation and so wants a higher return to compensate for that.
General and Specific rates of inflation:
Inflation is measured by measuring the prices of a set of goods and services (often described as a basket of goods
and services having different weightings) at various points in time, and then seeing by how much they have
increased or decreased. Some may rise, and some may fall, but the overall change in the price level is an
indication of the inflation level.
The inflation can be:
Specific General
Different for each cash flow item (e.g. sales price may be A single inflation rate for all cash flows
increasing by 5% whereas variable costs are subject to
an inflation rate of 4%.
Inflation rates might be:
Specific General
Specific for each coming year (e.g. 5% for year 1, 8% for A single rate for all coming years (e.g. Materiel cost is
year 2, 10% for year 3 and so on. expected to increase by 6% per annum over the life of
project.
Real Cash Flows and Money (Nominal) Cash Flows:
Real Cash Flows Money (Nominal) Cash Flows
Real cash flows are cash flows expressed in today’s price Money (nominal) cash flows are cash flows that include
terms. (They ignore the expectation of inflation). expected inflation. They are the actual amount of cash
received at a point in time
Note: Money cash flows can be derived from real cash flows by inflating the real cash flow by the rate of inflation
specific to that cash flow and vice versa.
Illustration # 32 Page # 35: (ICAP Example # 43)
A vendor sells ice creams. He knows that a bowl of ice cream sells for Rs. 50 today. He is planning future sales and expects to
sell 1,000 bowls next year and the year after. He expects inflation to be 10%. These future sales can be expressed in real terms
or in money terms.
Real Cash Flows
Year 1 cash sales (1,000 bowls Rs. 50) Rs. 50,000
Year 2 cash sales (1,000 bowls Rs. 50) Rs. 50,000
Money (Nominal) Cash Flows
Year 1 cash sales (1,000 bowls Rs. 50 1.1) Rs. 55,000
Year 2 cash sales (1,000 bowls Rs. 50 𝟏. 𝟏𝟐 ) Rs. 60,500
Real cost of capital and Money (nominal) cost of capital:
Real cost of capital Money (nominal) cost of capital
Real cost of capital is the return required by investors Money (nominal) cost of capital the return required by
measured in terms of a constant price level. It excludes investors measured in terms of a changing price level. It
the expectation of inflation. includes the expectation of inflation.
The real cost of capital and the money cost of capital are linked together by the following equation.
Formula:
The Fisher equation
1 + m = (1 + r) × (1 + i)
Where:
m = money rate
r = real rate
I = rate of inflation
The rate of inflation used above is the general rate of inflation.
Illustration # 33 Page # 36: (ICAP Example # 44)
A company has a money cost of capital of 12% and inflation is 5%. The real rate is?
1+m = (1 + r) × (1 + i)
1.12 = (1 + r) x (1.05)
Therefore, r = (1.12/1.05) – 1 = 0.0666 or 6.67%
Illustration # 34 Page # 36:
Suppose Bhola owns an investment portfolio. Last year, the portfolio earned a return of 3.25%. However, last
year’s inflation rate was around 2%. Bhola wants to determine the real return he earned from his portfolio.
In order to find the real rate of return, we use the Fisher equation.
The equation states that:
1+m = (1 + r) × (1 + i)
1 + 3.25% = (1 + r) x (1 + 2%)
r = 1.225%
Discounting money cash flows at the money cost of capital:
The cost of capital used in DCF analysis is normally a ‘money’ cost of capital. This is a cost of capital calculated from current
market returns and yields. When estimates are made for inflation in future cash flows, the rules are as follows:
Estimate all cash flows at their inflated amount. Since cash flows are assumed to occur at the year-end, they should
be increased by the rate of inflation for the full year.
To estimate a future cash flow at its inflated amount, you can apply a formula.
Formula:
CF at time n at inflated amount = CF at current price level × (1 + i)n
Where:
CF = Cash Flow i = The annual rate of inflation
All the cash flows must be re-stated at their inflated amounts. The inflated cash flows are then discounted at the money cost
of capital, to obtain present values for cash flows in each year of the project. These are netted to find the NPV of the project.
Discounting real cash flows at the real cost of capital
Instead of calculating the NPV of a project by discounting ‘money’ cash flows at the money cost of capital, NPV can be
calculated using a real cost of capital applied to cash flows at today’s prices. Discounting real cash flows using a real cost of
capital will give the same NPV as discounting money cash flows using the money cost of capital, where the same rate of
inflation applies to all items of cash flow.
Example # 16 Page # 37: (ICAP Example # 46)
A company is considering an investment in an item of equipment costing Rs. 150,000. Contribution per unit is
expected to be Rs.4 and sales are expected to be:
Year Units of sale
1 20,000
2 40,000
3 60,000
4 20,000
Fixed costs are expected to be Rs. 50,000 at today’s price levels and the equipment can be disposed of in year 4
for Rs. 10,000 at today’s price levels. Inflation rate is expected to be 6% and the money cost of capital is 15%.
Required:
(a) Calculate the NPV of the project by discounting real cash flows with real cost of capital.
(b) Calculate the NPV of the project by discounting money cash flows with money cost of capital.
