NAME: SHIAKA HARUNA

REG NO: 2001921014

COURSE: INVESTMENT AND PORTFOLIO MANAGEMENT
DEPT: BANKING AND FINANCE
LEVEL: HNDII
TITLE ASSIGNMENT
QUESTION
a. Define this term inflation and distinguish between money and cash flow and real
flow
b. Calculate money and real discount rate
c. Analyze the impact of inflation on investment decision and explain the treatment
of inflation and taxation in capital budgeting decision

INTRODUCTION
Inflation is the rate at which the cost of goods and services rises over time. It could also
be thought of as a reduction in the value of a dollar, because consumers are now able
to purchase less than they previously could with the same dollar bill. 
As a small business owner, you need to understand inflation and how it impacts your
company. “Inflation” is a buzzword that most people have heard but few really
understand. You might know that inflation has much to do with the price of goods and
services, but you’re not quite sure how they are related. Why does inflation occur,
where does it come from, and why does inflation matter to small businesses?

WHAT IS INFLATION?

Inflation is the decline of purchasing power of a given currency over time. A quantitative
estimate of the rate at which the decline in purchasing power occurs can be reflected in
the increase of an average price level of a basket of selected goods and services in an
economy over some period of time. The rise in prices, which is often expressed as a
percentage, means that a unit of currency effectively buys less than it did in prior
periods.

DIFFERENCE BETWEEN MONEY INCOME AND REAL INCOME MONEY

 Money Income:

1. The purchasing power of rupees over a given time period is referred to as money
income.

1
 2. Money is one of the most important material resources for a family. All gains
received in the form of rupees, coins, or notes over a specific time period, such
as daily, weekly, or monthly, are included in the family's money income.  
3. All monetary revenue, such as salary or wages, housing rent, gifts, interest
earned on bank accounts, and other investments are some examples of money
income.

 Real Income:

1. The flow of products, services, and community facilities available for a defined
period of time is referred to as real income.
2. For a family to live comfortably, the concept of actual income is critical. Both
producers and consumers' items are represented in real time.
3. For example: A family's heirloom landed property that generates crops. The food
comes from a kitchen garden. Two of the most prevalent types of farming are
dairy and poultry farming. Durable goods and commodities owned by the family,
etc.

DIFFERENCE BETWEEN CASH FLOW AND REAL FLOW

Circular flow of money is of two types - real flow and monetary flow. Simply flow of
goods and services is called real flow and flow of money (income) is called money flow.
(i) Real Flows. Real flows refer to flows of goods and services. These are called real
flows because they consist of actual goods and services. In the context of national
accounting, real flow implies flow of factor services from household sector to the firm (or
producing) sector and the corresponding flow of goods and services from firm sector to
the household sector. Thus flows of goods and services between firm sector and
household sector are real flows. Such flows are continuous and there is no beginning or
end point in these flows. In Fig.(a), the inner two arrows indicate real flows.
(ii) Money Flows. These refer to flows of money in the form of factor payments and
consumption expenditure. The monetary flows occur because it is through money that
various transactions are conducted bringing flows of money from one sector to another.
When factor incomes (rent, wages, interest and profit) flow from firm sector to the
households as reward for their factor services, these are called money flows.

2
CALCULATE MONEY AND REAL DISCOUNT RATE
Money
is any item or verifiable record that is generally accepted as payment for goods and
services and repayment of debts, such as taxes, in a particular country or socio-
economic context

The Discount Rate represents the minimum return expected to be earned on an

investment given its specific risk profile.

The real discount rate is used to convert between one-time costs and annualized costs.
HOMER calculates the annual real discount rate (also called the real interest rate or
interest rate) from the "Nominal discount rate" and "Expected inflation rate" inputs.
HOMER uses the real discount rate to calculate discount factors and annualized costs
from net present costs.

Depending upon the context, the discount rate has two distinct definitions and usages.

 The discount rate is the interest rate charged to commercial banks and other financial
institutions for short-term loans they take from the Federal Reserve Bank.
 The discount rate refers to the interest rate used in discounted cash flow (DCF) analysis
to determine the present value of future cash flows. 

Discount formula

The formula for discount is exactly the same as the percentage decrease formula:

discounted_price = original_price - (original_price * discount / 100)

How to calculate discount and sale price?

1. Find the original price (for example $90)

2. Get the the discount percentage (for example 20%)
3. Calculate the savings: 20% of $90 = $18
4. Subtract the savings from the original price to get the sale price: $90 - $18 = $72
5. You're all set!

3
IMPACT OF INFLATION ON INVESTMENT DECISIONS.

Prices do not remain constant over a period of time. They tend to change due to various
economic, social or political factors. Changes in the price levels cause two types of
economic conditions, inflation and deflation. Inflation may be defined as a period of
general increase in the prices of factors of production whereas deflation means fall in
the general price level.

These changes in the price levels lead to inaccurate presentation of financial

statements and also have a significant impact on investment decisions which can
be made clear with the help of the following example:

On comparing the return on capital employed as shown on historical cost concept which
is 30% we find that it is much higher than return on capital employed based on
replacement cost concept. In reality, we have earned only 10.83% on today’s capital. In
the same way the tax liability on the historical cost concept is Rs 2, 70,000 which is
much higher than the tax liability of Rs 1, 95,000 based in replacement cost concept.

The impact of inflation on investment decisions has been explained in the

following illustrations:

Illustration 1:

A company has under review a project involving the outlay of Rs 55,000 and
expected to yield the following cash flows in current terms:
The company’s cost of capital, incorporating a requirement for growth in dividends to
keep pace with cost inflation is 20% and this is used for the purpose of investment
appraisal. On the above basis, the divisional manager involved has recommended
rejection of the proposal. Having regard to your own forecast that the rate of inflation is
likely to be 15% in year 1 and 10% in each of the following years, your are required to
comment on his recommendation. (Discount factors at 20% are 0.833, 0.694, 0.579 and
0.482 respectively for year 1 to year 4).

4
Since the net present value in negative, the divisional manager has recommended
rejection of the proposal \However, we should calculate the net present value of
inflation adjusted cash inflows as below:

CAPITAL BUDGETING AND THE TREATMENT OF INFLATION

1. Forecasts Spread Over a Period of Time

Inflation is an ever persistent condition in today’s economy. The purchasing power of

money has been reducing year after year for decades now. Apart from the occasional
recession where money may gain real value, the usual case is a loss of value. Investors
are investing money today. They want to be compensated for the inflation and still get a
return over and above it. This simply means that they want to gain value in real terms.

It is important for us to understand this while coming up with our cash flow estimations.
This is because projects never give all of their cash flows in the same period. Cash
flows from projects are usually spread out over many years, even decades. The
treatment of inflation therefore becomes very important to come up with the correct
value. Minor changes in the assumptions about inflation are capable of producing
massive changes in the expected return from the project. A viable project may become

5
unviable simply by tweaking the inflation numbers a little bit. This article will explain how
inflation needs to be treated while performing these calculations:

2. Inflation Affects Different Components Differently

First, we need to understand that inflation never affects all the components of the
income statement uniformly. Therefore assuming a uniform rate for all the components
might give theoretically correct answers, but in practical life it will be a blunder. For
instance, consider the fact that labor costs will go up every year. Employees usually
expect to be paid a hike every year. Also, the cost of raw materials is expected to go up
every year. Tax rates change every year. However, the increase in sales price cannot
match these changes.

The Golden Rule

The golden rule when it comes to capital budgeting and inflation is that we must be
consistent in our treatments of inflation. The keyword is consistency. If we have real
cash-flows, we must discount them at the real rate of interest. On the other hand, if we
have nominal cash flows (usually the case), we must discount them at a nominal rate of
interest. This might seem obvious, but is a common mistake to use the wrong discount
rate.

We have earlier studied a formula to convert nominal rates to real rates and vice versa.
The formula is as follows:

(1 + nominal rate) = (1 + real rate) * (1 + inflation rate)

An Approximation to the Golden Rule

This formula maybe required if you are doing precise calculations. If the intent is to
come up with an approximate figure, simple back of the hand calculations will suffice.
Hence, if the nominal rate is stated at 12% and the inflation rate is stated at 4%, it is a
reasonable assumption to assume 4% as the real rate of return. Obviously the resultant
numbers will not be precise but they will provide a good approximation which is exactly
what is required sometimes.

6
REFERENCE
Khan, M. S., & Ssnhadji, A. S. (2001). Threshold effects in the relationship between
inflation and growth, IMF
Staff papers 48(1), 1-21. https://doi.org/10.2307/4621658
Madsen, J. B. (2003). Inflation and investment. Scottish Journal of Political Economy,
50(4), 375-397.
https://doi.org/10.1111/1467-9485.5004002
Nevile, J. W. (1975). Inflation, Company Profits and Investment. Australian Economic
Review, 8(4), 35-36.
https://doi.org/10.1111/j.1467-8462.1975.tb00046.x
Osakwe, L. O. (1982). The impact of Inflation on the Growth of the Nigerian Economy:
Statistical Evidence.
Inflation in Nigeria. Ibadan: NISER, 213-236.
Phelps, E. S. (1968). Money-wage dynamics and labor-market equilibrium. The Journal
of Political Economy,
79(4), 678-711. https://doi.org/10.1086/259438