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%.
Real cash flows and money (nominal) cash flows

Real cash flows are cash flows expressed in today’s

price terms. (They ignore the expectation of inflation).

Real cash flows

Year 1 cash sales (1,000 bowls Rs. 50) 50,000
Year 2 cash sales (1,000 bowls Rs. 50) 50,000
Money (nominal) cash flows are cash flows
that include expected inflation. They are the
actual amount of cash received at a point in
time

Money cash flows

Year 1 cash sales (1,000 bowls Rs. 50 1.1)
55,000
Year 2 cash sales (1,000 bowls Rs. 50 (1.1)^2)
60,500
Formula: The Fisher equation
1 + m = (1 + r) × (1 + i)
Where:
m = money rate
r = real rate
i= rate of inflation
A company has a money cost of capital of 12%
and inflation is 5%.

The real rate can be found as follows:

1 + m = (1 + r) × (1 + i)
1.12 = (1 + r) (1.05)
Therefore r = (1.12/1.05) – 1 = 0.0666 or 6.67%
There are two possible approaches to
incorporating the expectation of inflation into
NPV calculations. Either:

Real cash flows should be discounted at the real

cost of capital; or

Money cash flows should be discounted at the

money cost of capital.
A company is considering an investment in an item of equipment
costing Rs. 150,000. The equipment would be used to make a
product. The selling price of the product at today’s prices would be
Rs. 10 per unit, and the variable cost per unit (all cash costs) would
be Rs. 6.
The project would have a four-year life, and sales are expected to
be :
Year Units of sale
1 20,000
2 40,000
3 60,000
4 20,000
At today’s prices, it is expected that the equipment will be
sold at the end of Year 4 for Rs. 10,000.
There will be additional fixed cash overheads of Rs.
50,000 each year as a result of the project, at today’s price
levels.
The company expects prices and costs to increase due to
inflation at the following annual rates:
Item Annual inflation rate
Sales 5%
Variable costs 8%
Fixed costs 8%
Equipment disposal value 6%
The company’s money cost of capital is 12%
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. The inflation rate is
expected to be 6% and the money cost of capital is 15%.