| 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/(1.04*1.03*1.05)=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
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.
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 1st year inflation rate as well as 2nd 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 2nd 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.
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 1st year inflation rate as well as 2nd 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 2nd 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.
thank you .thank you very much for kishore and jithin
Gupta Sachdeva & Co. Chartered Accountants
New Delhi
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