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ACCA Applied Skills · Financial Management · Allowing for inflation and taxation in DCF

Orla Co is evaluating a project whose Year 1 cash flow is $150,000 in current prices. The cash flow is subject to specific inflation of 6% a year, whereas general inflation is 3% a year. The real cost of capital is 8%. Which approach gives the correct present value of the Year 1 cash flow, to the nearest $?

Inflate the cash flow at its specific rate of 6% and discount at the money rate of 11.24%, derived from the 8% real rate and 3% general inflation. This gives 159,000 divided by 1.1124, or $142,939. The real rate must not be applied to money flows.

  1. AInflate at 6% and discount at the money rate of 11.24%, giving $142,939Correct
  2. BInflate at 3% and discount at 8%, giving $143,056
  3. CInflate at 6% and discount at 8%, giving $147,222
  4. DInflate at 3% and discount at 11.24%, giving $138,889

Explanation

Money rate = 1.08 x 1.03 - 1 = 11.24%. Specific inflation applies to the cash flow: 150,000 x 1.06 = 159,000; discounted at 1.1124 gives $142,939. Discounting a specifically inflated flow at the real rate mixes real and money bases and is wrong.

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