Business Studies · Financial Management
A long-term project is being appraised where sales revenue is expected to inflate at 3% per year, while labor costs are expected to inflate at 6% per year. The general rate of inflation in the economy is 4%. Which statement correctly identifies the superior approach for dealing with these multiple inflation rates within a Discounted Cash Flow (DCF) appraisal?
Verified Solution4 OptionsUpdated: October 2026👁️1 View
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- 1Both approaches will yield the exact same Net Present Value (NPV) as long as the tax-allowable depreciation is inflated by the general rate of inflation.
- 2The real-terms approach is superior here because it simplifies the calculation by ignoring specific inflation rates and only considering the real cost of capital.
- 3Use a nominal-terms approach by inflating each specific cash flow by its own rate and discounting the resulting net cash flows at the nominal cost of capital.✓
- 4Use a real-terms approach by deflating all cash flows by the 4% general inflation rate and discounting at the real cost of capital.
Correct answer
Use a nominal-terms approach by inflating each specific cash flow by its own rate and discounting the resulting net cash flows at the nominal cost of capital.
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