ExpertEasy2 marksMultiple Choice
ACCA · Question 06 · Investment Appraisal
'AstroTour', a space tourism startup, is appraising a 10-year project. The company expects general inflation to be 4% per year. The real cost of capital is 8%.
If AstroTour decides to discount the project's cash flows using the nominal (money) cost of capital, how must the cash flows be treated to ensure a correct Net Present Value (NPV) calculation?
'AstroTour', a space tourism startup, is appraising a 10-year project. The company expects general inflation to be 4% per year. The real cost of capital is 8%.
If AstroTour decides to discount the project's cash flows using the nominal (money) cost of capital, how must the cash flows be treated to ensure a correct Net Present Value (NPV) calculation?
Answer options:
A.
The cash flows must be expressed in current, uninflated terms.
B.
The cash flows must include the effects of specific inflation.
C.
The cash flows must be discounted by the real rate first, then inflated.
D.
The cash flows must exclude tax effects, as tax is a real cash flow.
How to approach this question
Remember the golden rule of inflation in NPV: Discount nominal cash flows at the nominal rate, and real cash flows at the real rate.
Full Answer
B.The cash flows must include the effects of specific inflation.✓ Correct
The Fisher equation links real and nominal rates. The fundamental rule of investment appraisal under inflation is: discount nominal (money) cash flows at the nominal (money) cost of capital, or discount real cash flows at the real cost of capital. Therefore, if the nominal rate is used, the cash flows must be inflated to reflect expected future prices.
Common mistakes
Discounting real cash flows with a nominal rate, which double-counts the effect of inflation (resulting in an artificially low NPV).
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