ACCA Applied Skills · Financial Management

Allowing for Inflation and Taxation in DCF

Inflation and tax adjust a basic NPV so it matches real cash. Inflate cash flows at their own rates and discount at the nominal rate, or keep real flows and use the real rate. Then add tax on profits, tax savings from capital allowances, and working capital. Discount everything and sum.

What this chapter covers

This chapter takes the basic NPV method and makes it realistic. A simple NPV assumes flat prices, no tax and no extra investment in inventory or receivables. Real projects have none of these simplifications. Prices rise, governments tax profits and capital must be tied up in working capital.

You deal with four ideas in turn. First, the link between real and nominal cash flows and discount rates. Second, how to inflate individual cash flows when different items rise at different rates. Third, how to bring in tax on operating cash flows and the tax relief from capital allowances. Finally, you put everything into one NPV layout with working capital.

This chapter sits at the centre of investment appraisal in FM. It builds on the time value of money, NPV and the cost of capital. It leads on to IRR, payback, capital rationing, risk and sensitivity analysis and project appraisal questions. In the exam it appears in objective test questions and almost always in a 20-mark Section C question, so a clean method here pays off repeatedly.

Investment appraisal is one of the most heavily examined areas of FM, and a long NPV question with inflation, tax and working capital is a classic Section C task. The calculations follow a fixed routine, so well-prepared students can collect most of the marks. The same rules are tested in short objective questions, such as converting a real rate to a nominal rate or deciding which cash flows to inflate. Because objective questions are all or nothing, small slips in method cost you the whole question. Mastering this chapter gives you reliable marks and strengthens every later appraisal topic.

Allowing for inflation and taxation in DCF: topics in the order to study them

1Real vs Nominal Cash Flows and Discount RatesEverything else depends on matching the type of cash flow with the right discount rate, so learn this link first.
2Inflating Cash Flows and Specific vs General InflationOnce you know why nominal flows need a nominal rate, you can practise inflating each item at its own rate.
3Taxation in DCF and Capital AllowancesTax is added to a model you already understand, and you need the timing rules before you combine everything.
4Combined NPV with Inflation, Tax and Working CapitalThis brings all the earlier pieces into one full exam-style layout, so it comes last.

How to prepare Allowing for inflation and taxation in DCF

Treat this chapter as a routine you can run under time pressure. Learn each piece separately, then drill the full layout until it feels automatic.

Learn the Fisher relationship: (1 + nominal rate) = (1 + real rate) × (1 + inflation rate). Practise rearranging it for each unknown.
Practise the rule: nominal flows with the nominal rate, real flows with the real rate. Decide which route a question suits before you calculate.
Drill inflating cash flows with a factor of (1 + rate)^n, using separate rates for sales, costs and other items where the question gives them.
Practise tax in steps: taxable profit, tax payable, then timing. Check carefully whether tax is paid in the same year or a year later, and what the question states about allowances.
Build a standard NPV layout with columns for each year and rows for sales, costs, tax, capital allowance tax savings, working capital, and net cash flow. Reuse it every time.
Work the working capital rule: the cash flow each year is the change in the required balance, and it is usually recovered at the end. Inflate the balance itself if told to.
Finish with timed full questions of about 36 minutes for 20 marks. Then write a short conclusion on whether to accept the project, since Section C also rewards comment.

Common mistakes in Allowing for inflation and taxation in DCF

Mixing real cash flows with a nominal discount rate, or nominal flows with a real rate.
Fix: Write the type of rate and the type of cash flow side by side before you start. If they differ, convert one of them.
Adding the inflation rate to the real rate instead of multiplying the factors.
Fix: Always use (1 + real) × (1 + inflation) = (1 + nominal), and compute the exact figure.
Treating capital allowances as cash inflows.
Fix: Calculate the allowance, multiply by the tax rate, and include only that tax saving in the NPV.
Getting the timing of tax wrong, or moving only some tax flows when tax is delayed a year.
Fix: Add a separate tax row and read the timing statement first. Shift the entire row consistently.
Including depreciation, interest or sunk costs in the cash flows.
Fix: Test each item: is it a future, incremental cash flow caused by the decision? If not, leave it out. Remember depreciation is replaced by capital allowances.
Putting the whole working capital balance in as a cost each year instead of the change.
Fix: Build a small table of required balances by year, take the year-on-year difference, and show the recovery at the end.

Last-day revision: Allowing for inflation and taxation in DCF

Fisher: (1 + money rate) = (1 + real rate) × (1 + inflation).
Nominal cash flows use the nominal discount rate. Real cash flows use the real rate.
Inflate each cash flow at its own specific rate if given. Otherwise use the general rate.
Inflated flow = base flow × (1 + i)^n, where n is the number of years from now.
Tax is charged on taxable profit, not on cash flow. Capital allowances reduce taxable profit.
Capital allowances are not cash flows. Only the tax saved on them is a cash flow.
Follow the question's tax timing: same year or one year later. Move all tax flows the same way.
Ignore depreciation, financing costs and sunk costs. Include opportunity costs and relevant incremental costs.
Working capital cash flow equals the increase or decrease in the balance each year.
Recover working capital at the end of the project unless told otherwise.
Discount the net cash flow of each year, add the results, and accept if NPV is positive.
Finish Section C answers with a clear recommendation and any key assumption.

Allowing for inflation and taxation in DCF practice questions

Allowing for inflation and taxation in DCF in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Allowing for inflation and taxation in DCF: frequently asked questions

When should I use the real rate instead of the nominal rate?

Use the real rate when your cash flows are in today's money terms with no inflation added. Use the nominal rate when you have inflated the cash flows. Either route should give the same decision if the inflation rate is the same for all flows, so choose the quicker one. If different items inflate at different rates, the nominal route is usually required.

Do I inflate cash flows when the question gives a money cost of capital?

Yes, in most cases. A money (nominal) cost of capital goes with nominal cash flows, so inflate the flows by the relevant rates. Check whether the question says the figures are already in future prices, because then you should not inflate them again.

How do capital allowances affect an NPV?

They reduce taxable profit, which lowers tax payable. The cash benefit is the allowance multiplied by the tax rate, received at the time set by the tax timing in the question. The allowance itself is not a cash flow.

How is working capital treated in an NPV?

Only the change in working capital is a cash flow. An increase in the required balance is an outflow, and a decrease is an inflow. Normally the investment is released at the end of the project, so you show a recovery in the final year.

Is this chapter tested in objective questions or in Section C?

Both. Short objective questions test points such as the Fisher formula, which items to include, or the tax saving on allowances. A 20-mark Section C question usually asks for a full NPV with comment, so you need the complete layout and a clear conclusion.