Chapter 4 - Investment appraisal - Further aspects of discounted cash flows Flashcards
What is inflation?
a general increase in prices leading to a general decline in the real value of money
In times of inflation, the funding providers will require a return made up of what two elements?
- a real return for use of their funds
- an additional return to compensate for inflation
What is the overall return?
the overall return required from these two elements is called the money or nominal rate of return.
What is the formula that links real and money (nominal) returns?
(1 + i) = (1 + r)(1 + h)
r= real rate of return
h=inflation rate
i= money cost of capital (the company’s normal cost of capital)
Cash flows that have not been increased for expected inflation are described as what?
being in current prices or today’s prices
Cash flows that have been increase to take account of inflation are known as what?
as money cash flows or nominal cash flows
Money or nominal cash flows represent what?
the expected cash outflow or inflow to hit the bank account
Assume in the exam that cash flows are what kind unless stated otherwise?
money cash flows
What is the method with dealing with the real method?
Do NOT inflate the cash flows - leave them in current terms i.e., current prices, current cash flows
Discount using the real rate
What is the method with dealing with the money/nominal method?
inflate each cash flow by its specific inflation rate i.e., convert it to a money cash flow
Discount using the money rate
What would we use general inflation rates for?
to calculate discount factors, when calculating the real or money rate of return.HO
How do we convert current cash flows to money cash flows?
Inflate using specific rate
How do we convert money cash flows to real cash flows?
deflate using general rate
What are the 2 tax effects in investment appraisal?
- Tax on operating cash flows
- Tax relief on investment spending
What is tax on operating cash flows?
additional income = additional tax paid
additional costs = less tax paid
what is tax relief on investment spending?
Tax-allowable depreciation allowed as an expense against profits instead of depreciation
When is tax paid?
one year after the related operating cash flow is earned
What is the assumption with when an asset is bought?
Bought at time period t0
What is the assumption for the first tax-allowable depreciation is claimed?
time period t1
What is the assumption of when the first tax saving would be?
time period 2 t2
Initial investment is treated as what of working capital?
is a cash flow at the start of the project (t0)
If the investment is increased what is the treatment of the working capital?
The increase is a relevant cash outflow
If the investment is decreased what is the treatment of working capital?
the decrease is a relevant cash inflow
When is working capital ‘released’?
the end of the project, leading to a cash inflow
Working capital investment cash flows should add across to what?
0
If a question has both tax and inflation what method should be used?
money method
