Project cash flows, tax, and inflation - General vs specific...

Learning Outcomes

After studying this article, you will be able to distinguish between general and specific inflation in project cash flow appraisal, apply both real and nominal (money) terms approaches, explain when each method should be used, and incorporate tax effects into discounted cash flow calculations in line with ACCA FM requirements.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand how inflation and tax affect project appraisal calculations. Focus your revision on the areas below:

• The impact of inflation on investment project cash flows and discount rates
• The calculation and application of real and nominal (money) methods
• Identifying and inflating cash flows with appropriate inflation rates (general vs specific)
• Applying tax and tax-allowable depreciation in NPV calculations
• The selection and use of discount rates to match cash flow treatments
• Dealing with working capital and its inflation adjustment in NPV calculations

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which factor determines when the real method for NPV calculation can be applied instead of the money method?
   1. The length of the project
   2. The presence of tax
   3. Whether inflation rates are the same for all cash flows
   4. The number of cash flows in the project

2. True or false? When calculating project NPV, you should always inflate each cash flow using the general rate of inflation.

3. What is the correct pair for discounting in NPV calculations if using:
   1. Real cash flows—what discount rate?
   2. Money (nominal) cash flows—what discount rate?

4. A project has material costs inflating at 8% and sales at 5%, with general inflation at 6%. Can the real method be used? Why or why not?

Introduction

Projects rarely operate in a static economic environment. Inflation affects both revenues and costs, and the impact can vary between different types of cash flows. In project appraisal, getting inflation treatment wrong can materially affect decision-making. This article covers how to identify when to use the real or money (nominal) approach, how to deal with general versus specific inflation, and how tax interacts with these calculations for correct NPV assessment.

Understanding the correct approach is essential—many errors in the FM exam relate to inflating cash flows or matching them with the correct discount rate.

Key Term: general inflation
The overall increase in prices across a broad selection of goods and services, usually measured by a consumer price index, and used to adjust cash flows or discount rates for changes in purchasing power.

Key Term: specific inflation
The projected rate of price change applied to a particular item or category of cash flow within a project, reflecting that some costs or revenues may inflate at different rates than general inflation.

Key Term: real cash flows
Cash flows stated in constant purchasing power terms (today’s prices), not yet inflated for the effects of expected price increases.

Key Term: nominal (money) cash flows
Cash flows expressed in expected future prices, after applying inflation for each period. Also known as “money terms.”

Key Term: money (nominal) discount rate
The required rate of return that includes compensation for both the time value of money and expected inflation; used to discount money (nominal) cash flows.

Key Term: real discount rate
The required rate of return excluding inflation; used to discount real cash flows.

Inflation in Project Cash Flows: Core Principles

Correctly incorporating inflation is essential for realistic project appraisal. Inflation can affect different project cash flows at different rates. For instance, salaries, raw materials, and sales prices may each rise at their own “specific” inflation rates, rather than the economy-wide “general” rate.

When to Use the Real vs Money Method

Two main approaches exist:

a) Money (Nominal) Method:

• Inflate each future cash flow by its specific inflation rate to obtain its expected “money” value.
• Discount all money cash flows at the money (nominal) discount rate.

b) Real Method:

• Leave all cash flows in today’s (“real”) prices.
• Discount all real cash flows at the real discount rate.

Matching is key: “Real cash flows with real discount rate” and “Money cash flows with money discount rate.” Do not mix methods.

Key Term: real method
Appraising investments by leaving all cash flows in today’s prices and discounting at a real (inflation-adjusted) discount rate.

Key Term: money (nominal) method
Appraising investments by inflating all cash flows to expected future prices and discounting them using the nominal (money) discount rate.

General vs Specific Inflation—Which Rate to Use?

• If all project cash flows inflate at the same rate as general inflation, you may use either the real or the money method.
• If any cash flow has a different inflation rate (e.g., wages inflate at 5%, sales at 3%, general inflation at 4%), you must use the money method—inflate each flow by its own specific rate.

Exam Warning Do not automatically apply the general inflation rate to every cash flow. In many cases, exam questions state different inflation rates for various cash flows. Apply each rate only to its relevant item.

Money Discount Rate: Calculating When Not Given

If only the real discount rate (r) and general inflation rate (h) are provided, you must calculate the money discount rate (i):

$(1 + i) = (1 + r) \times (1 + h)$

where:

• i = money (nominal) rate
• r = real rate
• h = general inflation rate

Use this formula before discounting money cash flows, especially in mixed-inflation questions.

Inflation and Tax in Project Appraisal

Tax affects both operating flows and tax-allowable depreciation (“capital allowances”). In exam questions, unless told otherwise, assume:

• Taxable operating flows are calculated on money (inflated) cash flows.
• Tax-allowable depreciation uses cost figures (not inflated unless stated).
• Tax is usually paid one year in arrears.

Tax interacts with inflation in these ways:

• Compute tax on inflated (money) profits.
• When capital allowances are involved, calculate tax relief on deductions based on asset cost (inflated only if asset purchased in the future).

Key Term: tax-allowable depreciation
The portion of an asset’s cost that can be deducted for tax purposes (not an actual cash flow), reducing taxable profits and creating a tax saving (“capital allowance”).

Step-by-Step Framework for Projects with Inflation and Tax

1. Identify whether all or certain cash flows have specific inflation rates.
2. If all inflating at general rate—may use either real or money method. If any differ, use the money method.
3. Inflate each cash flow by its correct rate for each period.
4. Calculate the money (nominal) discount rate if only real rate and general inflation are given.
5. Apply tax on taxable profits (money flows)—usually one-year in arrears.
6. Calculate tax savings from tax-allowable depreciation (based on cost or write-down value per question).
7. Include working capital as a money cash flow—inflate if based on sales/costs that inflate.

Worked Example 1.1

A company is evaluating a 3-year project:

• Sales: $200,000/year, inflating at 4%
• Materials: $80,000/year, inflating at 7%
• Labour: $50,000/year, inflating at 5%
• General inflation: 4%
• Real discount rate: 6%
• Tax rate: 30%, paid one year in arrears
• Asset cost: $250,000, tax-allowable depreciation 25% reducing balance, asset bought immediately

Required:
Explain and show which inflation rates to use for each cash flow, and state the correct discount rate for NPV.

Answer:

• Sales will be inflated at 4% (their specific rate)
• Materials at 7% (their specific rate)
• Labour at 5% (their specific rate)
• Working capital based on sales must inflate at 4%
• Tax will be calculated on money (inflated) flows
• Since different inflation rates apply, only the money method may be used.
• Money discount rate $(1+i) = (1+0.06) \times (1+0.04) = 1.1024$
• So, use a 10.24% money rate to discount all inflated cash flows.

Worked Example 1.2

A project’s operating costs all increase at the general rate of inflation, but tax is payable at 25%, one year in arrears. The real post-tax discount rate is 5%, and general inflation is 3%. Should you use the real or money method?

Answer:

• If all cash flows inflate at the general rate, both the real method (discount at 5%) and the money method (discount at calculated money rate) will give the same result.
• In practice, when tax is present, use the money method unless the question specifically requests the real approach, since tax calculations are usually performed on money flows.

Worked Example 1.3

You are given a project where:

• Revenues inflate at 4%,
• Material costs at 8%,
• General inflation is 5%.

How should you treat the different flows?

Answer:

• Sales inflate at 4%, so each year’s revenue is prior year × 1.04.
• Materials inflate at 8%, so each year’s cost is prior year × 1.08.
• Tax, capital allowances, and working capital must be calculated on money flows.
• Discount all money flows at the correct money rate, found by combining the real rate with the general inflation rate.

Practical Steps in the Exam

1. Read the question carefully—identify all separate inflation rates.
2. Inflate each relevant cash flow at its specified rate for each year.
3. If tax is present, always calculate taxable profits and tax savings on money terms.
4. Obtain the correct money discount rate using the Fisher formula if given only the real rate.
5. Discount the cash flows—ensure you use the discount rate and cash flows that “match” (real with real, money with money).
6. State your method—explain why you chose it based on the presence of multiple inflation rates and/or tax.

Revision Tip In exam questions with both tax and multiple inflation rates, it is safer to use the money method—inflate each flow with its specific rate and discount at the calculated money rate.

Summary

Correctly treating inflation and tax is essential in project appraisal calculations. Use the money method (specific inflation for each cash flow and discount at the money rate) whenever cash flows inflate at different rates or if tax is involved. Only use the real method when all flows share a single inflation rate and the question allows. Always check that your discount rate and cash flows “match”—either both real or both money.

Key Point Checklist

This article has covered the following key knowledge points:

• Correct application of general and specific inflation in project cash flow appraisals
• When and how to use the real method versus the money method
• Calculating the money (nominal) discount rate using the Fisher formula
• Application of specific inflation rates to individual revenue and cost lines
• Incorporation of tax on operating flows and tax-allowable depreciation in NPV
• Treatment of working capital under inflation
• Aligning the treatment of cash flows and discount rates in all calculations

Key Terms and Concepts

• general inflation
• specific inflation
• real cash flows
• nominal (money) cash flows
• money (nominal) discount rate
• real discount rate
• real method
• money (nominal) method
• tax-allowable depreciation