Here, candidates had to calculate the net present value (NPV) of an investment project in real terms and comment on its financial acceptability. Answers tended to be of a slightly lower standard than answers for part (a).

Most candidates knew that a real discount rate was needed and correctly calculated that this was 7% (1.12/1.047) using the Fisher formula from the formulae sheet. Some answers incorrectly inflated the nominal discount rate and used 17% (1.12 x 1.047).

The correct approach was to discount real cash flows with the real cost of capital, so the cash flows given in the question were to be used, as only a general rate of inflation was provided. Some candidates incorrectly discounted the project cash flows they had calculated in part (a) with their calculated real cost of capital, which is incorrect as nominal cash flows must not be discounted with a real cost of capital.

Some candidates correctly used real terms sales revenue and costs, but then wrongly brought forward nominal working capital figures from part (a).

A small number of candidates deflated the nominal after-tax project cash flows from part (a) with the general rate of inflation to give real cash flows. While this approach was given credit, it was not quite correct, since cash flows that had not been inflated were thereby deflated (tax benefits of tax-allowable depreciation), and cash flows that had been inflated with one year’s inflation were thereby deflated with a different year’s inflation (tax liability in arrears, working capital invested at the start of the year).