Corporate Finance

190
Corporate Finance

Real cash flow = 100/1.04 = Rs 96.10

Consider another example:

Nominal Real
Year cash flow cash flow

1 1,000 952.3

2 2,000 1,818

3 3,000 2,593

4 4,000 3,292

Real cash flows have been calculated using an expected inflation of 5 percent, for all the years using the
relationship:

Real CFt= [Nominal CFt/(1 + i)t]
where t is the time period.
Real cash flow in year 2 = Nominal cash flow/(1.05)^2
Real cash flow in year 3 = Nominal cash flow/(1.05)^3 , etc.

It is to be noted that nominal rate should be used to discount nominal cash flows, and the real rate should
be used to discount real cash flows. If there is a mismatch between cash flows and discount rate, the result
will be erroneous. Another subtle effect of inflation is that asset values get eroded very fast in high inflation
environments. The depreciation provided on historical cost basis will be much lower than that on replacement
cost basis leading to fictitious earnings.
Inflation is the rise in the average price level, generally measured as the increase in the consumer price
index during the period. The increase in prices of goods and services that are of importance to the decision
maker may or may not have correlation with that in the general price rise. So taking the general inflation in
the economy as proxy for increase in the price of the firm’s inputs may be erroneous.
The implicit assumption in matching cash flow and discount rate is that the actual price increases equal
the inflation rate included in the discount rate. The price behavior may not have much correlation with
general inflation in the economy as measured by the increases in the consumer price index. Secondly, the tax
shield arising out of interest and depreciation affects the value of the project. The amount of depreciation
and interest charges under both the approaches might be the same but the relative value is greater with
constant prices. So the project will be undervalued in the constant price approach. Similar difficulties arise
when a company sells goods on credit and when dealing with hard currencies where inflation rates are not
exactly offset by currency depreciation.

CONFLICTS IN RANKING

The recommendation to accept or reject a project in case of conventional projects is that if NPV > 0; else
reject. Similarly, accept if IRR is > cost of capital; else reject. Both give similar results. A project that is
unacceptable on the basis of NPV would be unacceptable on the basis of IRR as well. But there are some
situations in which conflicts arise. A project acceptable on the NPV standard may have to be rejected on the
basis of IRR.