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# Corporate Finance - PowerPoint PPT Presentation

Corporate Finance. Lecture 4. Topics covered. Inflation in capital budgeting Interest rate and inflation rate Discounting with inflation Investment with unequal lives. Inflation and capital budgeting. Interest rates and inflation

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## PowerPoint Slideshow about 'Corporate Finance' - winola

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### Corporate Finance

Lecture 4

• Inflation in capital budgeting

• Interest rate and inflation rate

• Discounting with inflation

• Investment with unequal lives

• Interest rates and inflation

• The effect of inflation: The time value of money is deflated by inflation.

• Real interest rate vs. nominal interest rate

• Be consistent in how you handle inflation!

• Use nominal interest rates to discount nominal cash flows.

• Use real interest rates to discount real cash flows.

• Notice the treatment of depreciations in the two approaches: Depreciation is a nominal number!

• Approximation

• Real interest rate ≈

Nominal interest rate – Inflation rate

• The approximation is reasonably accurate when the interest rate and the inflation rate are low.

• Example. Monarchy of Gerberovia has a norminal interest rate of 300% and inflation rate of 280%.

• (1+300%)/(1+280%)-1=5.26%

• 300%-280%=20%

Example

You own a lease that will cost you \$8,000 this year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?

Example - nominal figures

Example - real figures

Cash flows and Discount rates: An example

Inflation rate =10%

Norminal rate =15.5%

(1+15.5%)/(1+1.10)-1=5%

Real rate=

• So far, the NPV rule has been our rule-of-thumb.

• However, there are situations when the NPV rule is not sufficient.

• E.g. when investments under decision have different lengths of life.

Discount rate=0.1

NPV rule will suggest Machine A because it has a lower NPV of costs……But, is this correct?

• The NPV rule does not consider the time that each machine will last.

• Machine A is cheaper but only last for three years.

• Machine B is more costly but last for one more year.

• Therefore, it is necessary to compare the cost on a per year basis.

• Annuity

• A: 798.42=C1*

C1=798/2.4869=321.05

B: 916.99=C2*

C2=916.99/3.1699=289.28

C1>C2, it is cheaper to buy machine B