Investment appraisal – Further aspects of discounted cash flows

Question 1

Inflation is

Answer 1

a general increase in prices leading to a general decline in the
real value of money

Question 2

In times of inflation, the fund providers will require a return made up of two
elements:

Answer 2

 real return for the use of their funds (i.e. the return they would want if there
were no inflation in the economy)
 additional return to compensate for inflation

The overall required return is called the money or nominal rate of return.

Question 3

The real and money (nominal) returns are linked by the formula:

Answer 3

(1 + i) = (1 + r)(1 + h)
where
i = money rate
r = real rate
h = inflation

Question 4

Note that the real method only applies if the rate of inflation of the specific cash
flows involved is

Answer 4

the same as the general rate of inflation.

Question 5

Money rate =

Answer 5

Inflation

Question 6

Real cash flows =

Answer 6

Cost of capital

Question 7

To convert money (nominal) cash flows into real cash flows, they need to

Answer 7

be deflated using the general inflation rate