a)a(a)Explain how inflation affects the rate of returnrequired on an investment project, and also explain the distinction between areal and a nominal (or ‘money terms’) approach to the evaluation of...

1. Explain how inflation affects the rate of return required on an investment project,
and also explain the distinction between a real and a nominal (or ‘money terms’)
approach to the evaluation of an investment project under inflation.
Ans. The general practice of calculating the returns of the investment projects are often
criticized for ignoring the impact of inflation on cash flows throughout the project life.
Presence of inflation (higher or lower) can totally distort the investment decisions and the
returns on the investments.
As the income grows, an increasing portion of the income is charged, as the depreciation is
always based on the original cost or the book value of the asset and not the market value.
Thus higher amount of income will be charged. Example as below:
Yearly cash inflow: US$ 60,000, Tax:50% of taxable income, Initial project cost: US$80,000,
Discount rate of 30%
Year Cash inflows Depreciation Tax Cash inflow
after tax
1 60,000 20,000 20,000 40,000
2 60,000 20,000 20,000 40,000
3 60,000 20,000 20,000 40,000
4 60,000 20,000 20,000 40,000
Option 1: Assuming no inflation
Given the depreciation is US$ 20,000, taxable income for each of the year is US$40,000.
Thus at 50% tax rate, tax each year is US$20,000. So the NPV of the project which can be
calculated by the formulae:
∑(

( )
)
Here CFt is the cash inflow after tax at time t, Cot is the cash outflow at time t, K is the cost
of capital, t is the time period, and Co is the initial outflow.
Using the above equation we...