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Inflation in capital budgeting

gillbates (student) (277 Points)

27 June 2013

Nominal cash flows	Inflation rate	Real cash flows
200	4%	200/1.04=192.31
-400	3%	-400/(1.04*1.03)=373.41
1000	5%	1000/(1.041.031.05)=889.07

for calculating real cash flows we know that (Nominal cash flows / (1+inflation rate))

My doubt is in year 2 why we again discounted the 4% inflation rate that is 400/(1.04*1.03)

why it has n't take like this 400/(1.03)=388.34

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4 Replies

Ki$hor B (Training & Advisory) (3015 Points)
Replied 27 June 2013

Firstly, CFs of Year 2 are discounted at the inflation rate applicable for yr2.

then, discounted with inflation rate of yr1, now the Cf is as in yr '0'

Similarly, CF of yr 1 is disc. with resp. inflation rate to make it

data relevant for yr '0'.

Now, both the CFs are at the same level for decision making.

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Jithin (Learner) (1057 Points)
Replied 27 June 2013

Yeah agree with Kishor..

Dear Gillbates, when u discount by just 3%, u are only wiping off the inflation effect of year 2..but inflation of year 1 remains..If u want to get the real cash flow, u have to discount by both 1^st year inflation rate as well as 2^nd year inflation rate. For example a pen costs Rs20 now. Its price increases by 5% in the next year(assume it is only bcoz of inflation). Now the price is Rs21. One more year later,the price increases by 10%(this time too, assume it is only due to inflation). So the price after 2 years is Rs.23.10. Now what is the real price after eliminating the inflation effect. If u just discount Rs23.10 by 10%(the inflation rate for 2^nd year), u get Rs21. Is Rs21 the real price? U know that the real price isn’t Rs 21 but Rs20. Now how do we get it..just by discounting 23.1 by 10% as well as 5%,i.e. 23.1/(1.05*1.10)=Rs20.