An example of an investment appraisalConsistency of approach
In principle it does not matter whether money cash flows or real ones are used in
the NPV analysis, provided each is used in conjunction with the appropriate dis-
count rate.
Where the cash flows are estimated in money terms (that is, incorporating the fore-
cast effects of inflation), then the discount rate must also reflect inflation expectations.
Therefore the discount rate should be based on the money cost of capital.
If the cash flows are to be assessed in real terms, then the discount rate must be
based on the real cost of capital.
It is important that there is consistency of approach. To use real cash flows in
conjunction with a money discount rate, for example, would be to understate the NPV
of the project, which could quite easily lead to desirable projects being rejected. A sur-
vey conducted in the UK during the 1970s by Carsberg and Hope (1976) suggested
that this rejection of desirable projects, resulting from wrongly dealing with inflation,
was indeed a problem.
Drury, Braund, Osborne and Tayles (1993) surveyed 260 UK manufacturing
businesses, seeking information on various aspects of capital investment appraisal.
They found that only 27 per cent of those businesses dealt correctly with inflation, and
13 per cent of the businesses surveyed made an error that was probably not very
significant. This left 60 per cent of businesses dealing with inflation in such a manner
as to give a significantly misleading result. However, Al-Ali and Arkwright (2000)
found that only 3 per cent of the 73 respondents to their survey of large UK businesses,
conducted in late 1997, mishandled inflation. This could imply an increasing level of
sophistication among financial managers. Al-Ali and Arkwright also found that about
half of their respondents took a ‘real’ approach, and the other half a ‘money’ one.
Dealing with cash flows and the discount rate in real terms does not completely
avoid forecasting the rate of inflation. Real costs of capital are not directly identifiable
in the way that money rates are. Money rates on government borrowings, for exam-
ple, are quoted daily in several national newspapers. Money rates can be converted
into real rates by adjusting for expectation of future inflation rates that are incor-
porated in them. To identify inflation rate expectations, it is probably best to take some
average or consensus view from the various economic forecasts that are published
regularly by a number of commercial and academic institutions, and also by the Bank
of England for the UK.
The central point regarding inflation in investment decisions is that it cannot
be ignored, not as long as inflation runs at significant rates. Not only must it be
confronted but also consistency of approach must apply. Money cash flows must be
discounted at money discount rates and real cash flows at real discount rates.
For some purely practical reasons, that we need not pursue here, using real cash
flows and a real discount rate tends to make the calculations problematical. It is
normally more straightforward to use their money counterparts.5.7 An example of an investment appraisal
Having considered the practical aspects of applying the NPV rule in principle, we
shall now go on to see how it would be applied to a practical example.