Untitled-29

Capital Budgeting Evaluation Techniques^129

substituting the values,

(l + r) = 1.12/1.05 = 1.0667

r = 0.0667 or 6.67 per cent.

or

Since the discount rate now to be used is the real discount rate, the CFAT should also

be adjusted for inflation so that they too are expressed in real terms. In operational

terms, CFAT will be deflated by the inflation rate (5 per cent). While Table 5.1 shows

real/ defleted CFAT, NPV of real CFAT is provided in Table 5.2

Real Cash Flows

Table 5.1

NPV Using Real Rate of Discount

Table 5.2

Please note that 'real cash flows discounted at the 'real' discount rate yield an identical

amount of NPV that is obtained by discounting 'nominal' cash flows by the 'nominal'

discount rate. When estimates of CFAT and cost of capital include inflation, they are

said to be expressed in nominal terms; when such estimates exclude the impact of

inflation, they are said to be shown in real terms. For correct analysis, these estimates

should either be stated in nominal or real terms. It implies that capital budgeting decisions

should either reckon the inflation factor in CFAT, as well as the cost of capital, or

exclude it completely.

Year CFAT (Rs.) Deflation factor at 0.05 Real CFAT (Rs.)

1 5,00,000 1/(1.05) = 0.952 4,76,00

2 4,00,000 1/(1.15)^2 = 0.907 3,62,800

3 2,00,000 1/(1.15)^3 = 0.864 1,72,800

4 1,00,000 1/(1.15)^4 = 0.823 82,300

5 1,00,000 1/(1.15)^5 = 0.784 78,400

Year Real CFAT PV factor at 6.67% Total PV

1 4,76,000 0.938 4,46,488

2 3,62,800 0.879 3,18,901

3 1,72,800 0.824 1,42,387

4 82,300 0.772 63,536

5 78,400 0.724 56,761

10,28,073

7,00,000

Gross present value

Less: Cash outflows

Net present value 3,28,073