Financial Management · Allowing for inflation and taxation in DCF

Inflating Cash Flows: Specific vs General Inflation in DCF

Updated 11 October 2026 · Fact-checked

General inflation is the average rise in prices across the economy. Specific inflation is the rise in one cash flow, such as wages. Inflate each cash flow at its own rate and discount at the money (nominal) rate. If all flows rise at the general rate, you can use real flows and the real rate instead.

Understand Inflating Cash Flows and Specific vs General Inflation

Prices rise over time. A cash flow you expect in three years will usually be larger in money terms than the same flow at today's prices. If you ignore this, your NPV will be wrong, because the discount rate you use already includes the effect of inflation.

General inflation is the average rise in prices across the whole economy. It is what turns a real cost of capital into a money cost of capital. Specific inflation is the rise in the price of one item, such as labour, materials or the selling price of your product. It can be higher or lower than general inflation.

There are two consistent ways to do the NPV. In the money (nominal) method, you inflate every cash flow to the amount you expect to receive or pay, then discount at the money cost of capital. In the real method, you keep cash flows at today's prices and discount at the real cost of capital. Never mix them. Inflated flows with a real rate overstate the NPV. Uninflated flows with a money rate understate it.

The choice depends on the data. If every cash flow rises at the same general rate, both methods give the same NPV, and the real method is quicker. If cash flows have different specific rates, you must use the money method. Each flow is inflated at its own rate, and then you discount at the money rate.

The cost of capital in a question is usually a money rate, because it comes from market returns. Check the wording. If you are given a real rate and general inflation, convert to a money rate with the Fisher relationship.

Key rules to remember

Inflating a cash flow: Money cash flow in year n = current-price cash flow × (1 + i)ⁿ; Use the specific rate i for that item. If the base is 'year 1 prices', inflate only from year 1, so the exponent is n − 1.
Fisher relationship: (1 + money rate) = (1 + real rate) × (1 + general inflation rate); Multiply the factors. Do not simply add the rates. Rearrange to find the real rate or inflation rate.
Money method rule: Money (inflated) cash flows ÷ money discount rate; Required whenever cash flows have different specific inflation rates.
Real method rule: Real (current-price) cash flows ÷ real discount rate; Valid only if every cash flow rises at the general inflation rate.
Net cash flow: Net cash flow = inflated receipts − inflated payments; Inflate each line separately first, then net them. Netting first hides different inflation rates.

How to solve Inflating Cash Flows and Specific vs General Inflation questions

Use this method for any question that asks you to allow for inflation in an NPV.

1Read the wording for each cash flow. Is it at current prices, or already in money terms? Note the base year of the prices.
2List every inflation rate given: general inflation and any specific rates. Match each cash flow to its rate. If no specific rate is given for a flow, use general inflation.
3Decide the method. If rates differ, use the money method. If all flows rise at the general rate and a real rate is available, the real method is a valid shortcut.
4Find the discount rate. Use the money rate as given. If you have only a real rate, convert it with (1 + m) = (1 + r) × (1 + i).
5Inflate each cash flow separately for each year. Then calculate the net cash flow for each year.
6Apply discount factors from the tables. Time 0 flows are not inflated or discounted.
7Add the present values and subtract the initial investment. State the NPV and the decision: accept if positive.
8If asked, comment briefly on how sensitive the NPV is to the inflation assumptions.

Quickest way: Year-by-year inflation table

When to use it: Use this in Section C when several cash flows have different specific rates over three to five years.

Draw columns for years 0 to n and rows for each cash flow item.
For each row, build the inflation factor year by year: multiply the previous year's money figure by (1 + rate). This avoids calculator power errors.
Write net cash flow in one row, then the discount factor row, then the present value row.
Check one figure by hand. For example, year 2 should be the current-price flow × (1 + i)².
In an objective test question, first ask whether the rates differ. If all flows share the general rate, discount real flows at the real rate and skip the inflation step.

Common mistakes in Inflating Cash Flows and Specific vs General Inflation

Discounting inflated cash flows at the real rate (or real cash flows at the money rate).
Students inflate the flows to be thorough but forget that the question gave a real rate, or vice versa.
Fix: Label each rate and each cash flow as 'real' or 'money' before calculating. Methods must match.
Applying general inflation to every cash flow when specific rates are given.
General inflation feels like the default, and the specific rates are easy to overlook in a long scenario.
Fix: Underline every rate in the question and assign it to an item. Use general inflation only for items with no specific rate.
Using the real method when specific rates differ.
The real method is shorter, so students choose it without checking the condition.
Fix: Use the real method only if all flows rise at the general rate. Otherwise inflate each flow and use the money method.
Adding the rates to get the money rate, for example 5% + 10% = 15%.
Adding looks natural and is close when rates are small.
Fix: Multiply: 1.05 × 1.10 = 1.155, so the money rate is 15.5%.
Inflating from the wrong base year, or inflating time 0 cash flows.
Students are unsure whether 'current prices' means year 0 or year 1.
Fix: Current prices means now (time 0), so year 1 is inflated once. If a flow is stated in year 1 prices, it is not inflated for year 1. Time 0 flows are never inflated.
Netting receipts and costs before inflating them.
It saves a step, but sales and costs usually have different specific rates.
Fix: Inflate each line on its own, then subtract.

Worked examples

Example 1

A project needs an initial outlay of $100,000 now. At current prices, annual sales are $90,000 and annual cash costs are $40,000 for three years. Sales prices rise by 5% a year and costs by 3% a year (specific inflation). The money cost of capital is 10%. Ignore tax. Calculate the NPV. Discount factors at 10%: year 1 0.909, year 2 0.826, year 3 0.751.

Show the solution

Rates differ, so use the money method with the 10% money rate.
Inflated sales: year 1 = 90,000 × 1.05 = $94,500. Year 2 = 90,000 × 1.1025 = $99,225. Year 3 = 90,000 × 1.157625 = $104,186.25.
Inflated costs: year 1 = 40,000 × 1.03 = $41,200. Year 2 = 40,000 × 1.0609 = $42,436. Year 3 = 40,000 × 1.092727 = $43,709.08.
Net cash flows: year 1 = $53,300. Year 2 = $56,789. Year 3 = $60,477.17.
Present values: 53,300 × 0.909 = $48,449.70. 56,789 × 0.826 = $46,907.71. 60,477.17 × 0.751 = $45,418.36.
Total PV = $140,775.77. NPV = 140,775.77 − 100,000 = $40,775.77.

Answer: NPV is about $40,776 positive, so the project is financially acceptable.

Example 2

A project costs $110,000 now and produces net cash flows of $50,000 a year for three years at current prices. All flows rise at the general inflation rate of 10% a year. The real cost of capital is 5%. Calculate the NPV using the real method, and show that the money method gives the same result. The 3-year annuity factor at 5% is 2.723.

Show the solution

All flows rise at general inflation, so the real method is valid.
Real method: PV = 50,000 × 2.723 = $136,150. NPV = 136,150 − 110,000 = $26,150.
For the money method, first find the money rate: 1.05 × 1.10 = 1.155, so 15.5%.
Money cash flows: year 1 = 50,000 × 1.10 = $55,000. Year 2 = 50,000 × 1.21 = $60,500. Year 3 = 50,000 × 1.331 = $66,550.
Discount at 15.5%: 55,000 ÷ 1.155 = $47,619. 60,500 ÷ 1.334025 = $45,351. 66,550 ÷ 1.540799 = $43,192.
Total PV = $136,162. NPV = $26,162.
The small difference ($12) is only rounding in the annuity factor. Each money flow divided by its money factor equals the real flow divided by its real factor.

Answer: NPV is about $26,150 (real method, using table factors). The money method gives about $26,162, the same apart from rounding. Accept the project.

Exam tips

Look at the wording: 'at current prices', 'in money terms', 'real cost of capital'. This tells you what must be inflated and which rate to use.
If specific rates differ, go straight to the money method and set out a clear year-by-year table. Markers give credit for clear working even if one figure is wrong.
In objective questions, check the method matches the rate first. Many wrong options come from mixing real flows with a money rate.
Show the Fisher calculation as a multiplication. Writing '1.05 × 1.10' earns method marks and avoids the adding mistake.
Keep unrounded inflated figures in your working and round only at the end, unless the question tells you otherwise.

Practice questions from Allowing for inflation and taxation in DCF

Inflating Cash Flows and Specific vs General Inflation: frequently asked questions

What is the difference between specific and general inflation in NPV?

General inflation is the average price rise across the economy and is used to link real and money discount rates. Specific inflation is the rise in the price of one item, such as wages or selling price. In an NPV, you inflate each cash flow at its own specific rate.

When should I use the real method instead of the money method?

Use the real method only when every cash flow rises at the general inflation rate and you have a real discount rate. It is quicker because you skip inflating each flow. If specific rates differ, you must use the money method.

How do I convert a real discount rate to a money rate?

Multiply the factors: (1 + money rate) = (1 + real rate) × (1 + inflation rate). For example, 5% real and 10% inflation gives 1.05 × 1.10 = 1.155, so 15.5%. Do not just add the two rates.

Do I inflate the initial investment at time 0?

No. A cash flow at time 0 happens now, so it is already in today's money and is not discounted either. Inflation applies only to later years, unless the question says the cost will rise before it is paid.

Why do the real and money methods give the same answer?

When all flows rise at the general rate, inflating a flow and discounting at the money rate cancels out the inflation effect. That leaves the real flow discounted at the real rate. The methods agree, apart from rounding.