stillwater hospital is borrowing 1 000 000 for its medical office building the annua 613244

Effect on future profits of choosing a real or nominal discount rate

A provision is required to be set up for an expected cash outflow of €100,000 (estimated at current prices), payable in three years’ time. The appropriate nominal discount rate is 7.5%, and inflation is estimated at 5%. If the provision is discounted using the nominal rate, the expected cash outflow has to reflect future prices. Accordingly, if prices increase at the rate of inflation, the cash outflow will be €115,762 (€100,000 × 1.05³). The net present value of €115,762, discounted at 7.5%, is €93,184 (€115,762 × 1 ÷ (1.075)³).

If all assumptions remain valid throughout the three-year period, the movement in the provision would be as follows:

If the provision is calculated based on the expected cash outflow of €100,000 (estimated at current prices), then it needs to be discounted using a real discount rate. This may be thought to be 2.5%, being the difference between the nominal rate of 7.5% and the inflation rate of 5%. However, it is more accurately calculated using the Fisher relation or formula as 2.381%, being (1.075 ÷ 1.05) – 1. Accordingly, the net present value of €100,000, discounted at 2.381%, is €93,184 (€100,000 × 1 ÷ (1.02381)³), the same as the calculation using future prices discounted at the nominal rate. If all assumptions remain valid throughout the

three-year period, the movement in the provision would be as follows: