ACCA Applied Skills · Financial Management · Allowing for inflation and taxation in DCF
A company forecasts a cash inflow of $200,000 in year 3 in today's prices. Specific inflation on this cash flow is 4% per year. What is the money (nominal) cash flow to be used in year 3 when discounting at the money cost of capital, to the nearest $?
The nominal year 3 cash flow is $224,973. Current-price cash flows are inflated at the specific inflation rate, compounded for three years: 200,000 multiplied by 1.04 cubed, which is 1.124864. Nominal flows are then discounted at the money cost of capital.
- A$177,793
- B$200,000
- C$224,973Correct
- D$224,000
Explanation
Inflate the current-price cash flow by the specific rate for three years: 200,000 x 1.04^3 = 200,000 x 1.124864 = $224,973. Using simple inflation (3 x 4%) gives $224,000, which ignores compounding. Deflating gives $177,793, which is the wrong direction.
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