ACCA FM Syllabus D. Investment Appraisal - Inflation basics - Notes ^{1 / 4}

An increase in prices (just in case you really are a mentalist). This means, therefore, that the real value of the same amount of money will decline over time

Now let’s compare that to another concept… that of interest ..

This is the rate of return required by a lender - this may be quoted at a rate that includes inflation (money rate) or a rate which doesn’t (real).

The real rate then means that the lender wants this on top of the inflation rate. Anyway more of that in the next section - I just wanted to introduce it to you here

Illustration

• Let’s say that inflation is 2%. If you have £100 now and don’t spend it, the £100 won’t be able to buy as much as it could at the start of the year because prices have increased by 2%.

• Therefore to stop this fall in value, many people put the money in a bank. They may get an interest rate of say 5%. This would represent a return over and above the inflation rate.

• Although the calculation ISN’T quite this straightforward (see later), basically if you get a 5% interest rate, and inflation is 2%, then you have received around a 3% return over and above the inflation rate. We call this rate the REAL return

NPVs and Inflation

1. Include it in the cash flows, using the different rates given

2. Include an inflation adjustment even for year 1 (as this is strictly the END of year1)

3. Include the GENERAL inflation in the discount rate by using a money or nominal rate (see later)

Calculation

Eg Sales 100 per year in real terms for 3 years. Price inflation is 10% pa

• Your NPV would show: