Candidates were asked here to discuss the difference between a nominal (money terms) approach and a real terms approach to calculating NPV. Answers were often poor and showed a lack of understanding, even though candidates had just carried out a nominal NPV evaluation correctly in part (a).

It must be understood that both approaches to calculating NPV give results that are essentially the same. If the information in part (a) had been used in a real terms approach, the calculated nominal cash flows would have needed deflating by the general rate of inflation to give real cash flows, the nominal after-tax cost of capital would have needed deflating by the general rate of inflation to give the real after-tax cost of capital, and the NPV would have been calculated by discounting the real cash flows by the real after-tax cost of capital.

To find real cash flows, which are cash flows expressed in current price terms, we need to inflate by the specific rates of inflation and then deflate by the general rate of inflation. Of course, if there is only the general rate of inflation on offer, there is no need to inflate and then deflate to find real cash flows, which is what may have confused some candidates.

Candidates who said that a nominal approach to calculating NPV took account of inflation, while a real terms approach ignored inflation, were therefore showing an imperfect understanding of the difference between the two approaches.

Some candidates said that the real terms approach would lead to a higher NPV because the real cost of capital was lower, demonstrating this by discounting the nominal cash flows from part (a) with a calculated real cost of capital. However, the golden rule is to discount real cash flows with the real cost of capital, and to discount nominal cash flows with the nominal cost of capital.