Real or Nominal GTG Studytext

[Acid]

Can anyone please guide us to the question by Mtandon?

Thanks


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HI, Acid ,
I am back again with a problem.

In capital budgeting , with Inflation effect::

As I understand, the nominal cash flows needs to be discounted using nominal cost of capital and real cash flows needs to be discounted using real cost of capital. Right? I think I am.

Now the real question:
In the question if real cost of capital is given and Inflation rates are different for sales price, variable cost, fixed cost etc, then how to arrive at the nominal rate to discount the cash flows.

Also if u see the GTG for F9 chapter D4 (test yourselg question) , there is a question where real cost of capital is given 8% and I dont know how in this world, the answer is with using 16% cost of capital.I think it should be discounted using nominal cost of capital which is neither 8% nor 16%.

Now I think if in question if nothing is qritten abt if its real cost of cap or nominal, no need to break yr head for calculating nominal cost of capital but assume its nominal!! isnt it??

I am looking for the answer. please help.

Thanks
Mohit
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[Kevin]

You have rightly pointed out that the real cash flows should be discounted using the real cost of capital and the nominal cash flows should be discounted using the nominal cost of capital. Also neither 8% nor 16% will be used for discounting.
Reference GTG study text, chapter D4, the discounting rate of 16% used in the answer is incorrect. This has already been noted and would be rectified in the subsequent F9 editions.

Now the answer to the query:

The rate of discounting should be calculated using the following formula:
(1 + Nominal rate) = (1 + Real rate) x (1 + Inflation rate)

Therefore, subsituting the values in the above formula, we get:
(1 + Nominal rate) = (1 + 0.08) x (1 + 0.06)
Therefore, Nominal rate = 1.14 - 1.00 = 0.14 or 14%

Hope this clarifies.

[haha]

Just wondering if you try to use 1+i=(1+r)(1+h) to find your inflation rate or real rate.

i= money rate
r= real rate
h= inflation rate

[Acid]

Hi

Can anyone please guide us to the query by Mtandon ?

Thanks


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When I apply inflation rates to cash flows, it becomed nominal cash flows.So I need the nominal discount rate now to calculate NPV.Now in question if real cost of capital is given, how can i calculate the nominal discount rate since for each item (like selling price, variable cost etc) the inflation rate is different.

Hope u understand my point.

Also there is a limit to messages on thsi blog so it would be great if u reply to my general question (posted under F9 forum) as asked before.so that I can ask again.

Thanks ACID

Mohit


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[Kevin]

In most of the cases, the question would mention the general rate of inflation. This would help you in calculating the nominal rate. The selling price and variable cost inflation will not be used for calculating the nominal rate of inflation. These would however, need to be applied while calculating the cash flows.