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128 Financial Management

return. Example 2.2 highlights that firms (conscious of protecting the real purchasing

power of their owners) may go for unprofitable investment projects, affecting the

shareholders wealth adversely. It underlines the significance of incorporating the inflation

factor in evaluating capital budgeting decisions, in particular for business firms interested

in real returns.

Consistency warrants that the real cost of capital should be used to discount real cash

inflows after taxes and the nominal cost of capital should be employed for

nominal CFAT. This point is illustrated in Example 2.3. The investment data of Rajiv

Company Ltd. Launching a new product and with 12 per cent cost of capital, is as

follows:

Example 2.3

Assuming an inflation rate of 5 per cent, determine NPV of the project by using both

the nominal rate of discount and the real rate of discount.

Solution

NPV Using Nominal Rate of Discount

The nominal rate of discount (n) is obtained by compounding the real rate (r) and

inflation rate (i). In equations terms, it is

(l + n) = (1 + r) (l + i)

(l + r) = (1 + n) (l + i)

or

Particular Amount

Investment Rs.7,00,000

CFAT: Year 1 5,00,000

2 4,00,000

3 2,00,000

4 1,00,000

5 1,00,000

Year CFAT (Rs.) PV factor at 0.12 Total PV (Rs.)

1 5,00,000 0.893 4,46,500

2 4,00,000 0.797 3,18,800

3 2,00,000 0.712 1,42,400

4 1,00,000 0.636 63,600

5 1,00,000 0.567 56,700

10,28,000

7,00,000

Gross present value

Less: Cash outflows

Net present value 3,28,000