ACCA Applied Skills · Financial Management · Allowing for inflation and taxation in DCF
Zeta Co is appraising a project using a money (nominal) cost of capital of 12.0%. The general rate of inflation is expected to be 5.0% a year. What is the real cost of capital, to the nearest 0.1%?
The real cost of capital is 6.7%. It is found by dividing one plus the money rate by one plus the inflation rate, so 1.12 divided by 1.05 equals 1.0667. Simply subtracting 5% from 12% ignores compounding and is wrong.
- A6.7%Correct
- B7.0%
- C17.6%
- D7.6%
Explanation
Real rate = (1.12 / 1.05) - 1 = 1.06667 - 1 = 6.7%. Subtracting 5% from 12% gives 7.0%, which ignores the compounding link between the rates. Adding them in the Fisher formula the wrong way gives 17.6%.
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