per cent. Assume cash flows arise on the final day of each year. The calculation of the present value is shown in Table 12.3. Now assume there is a forecast of 5 per cent inflation each year for the next three years. If the cash flows are adjusted for the effect of inflation then the discount rate must also be adjusted.
The discount rate is adjusted using the formula (1 ??i)(1 ??r) where i ??the rate of inflation and r ??the inflation free cost of capital.
In this example the calculation is (1 ??i)(1 ??r) ??(1.05)(1.04) ??1.092
The discounting of the inflation adjusted cash flows is shown in Table 12.4.
Table 12.4
Calculation of present value, with adjustment for inflation
|
Present value |
|
|
|
|
|
|
|
|
|
Year 1 |
|
Year 2 |
|
Year 3 |
|
|
= |
10,500 (1 + r) |
+ |
11,025 (1 + r)2 |
+ |
11,576 (1 + r)3 |
|
|
= |
10,500 (1 + 0.092) |
+ |
11,025 (1 + 0.092)2 |
+ |
11,576 (1 + 0.092)3 |
|
|
= |
10,500 (1.092) |
+ |
11,025 (1.1925) |
+ |
11,576 (1.3022) |
|
|
= |
9,615 |
+ |
9,245 |
+ |
8,890 |
|
|
= |
£27,750 |
|
|
|
|