Cost Accounting (14th Edition)

APPENDIX 763
occur at the end of each year. If inflation of 10% is expected each year, net cash inflows from the sale of each unit
would be $11 ($10 * 1.10) in year 1 and $12.10 ($11 * 1.10, or $10 * (1.10) 2 ) in year 2, resulting in net cash inflows
of $1,100 in year 1 and $1,210 in year 2. The net cash inflows of $1,100 and $1,210 are nominal cash inflows because
they include the effects of inflation. Nominal cash flows are the cash flows that are recorded in the accounting system.
The cash inflows of $1,000 each year are real cash flows. The accounting system does not record these cash flows. The
nominal approach is easier to understand and apply because it uses nominal cash flows from accounting systems and
nominal rates of return from financial markets.
Assume that Network Communications can purchase equipment to make and sell a cellular data-transmission
product at a net initial investment of $750,000. It is expected to have a four-year useful life and no terminal disposal
value. An annual inflation rate of 10% is expected over this four-year period. Network Communications requires an
after-tax nominal rate of return of 32% (see p. 762). The following table presents the predicted amounts of real (that’s
assuming no inflation) and nominal (that’s after considering cumulative inflation) net cash inflows from the equipment
over the next four years (excluding the $750,000 investment in the equipment and before any income tax payments):
Year Before-Tax Cash Inflows in Real Dollars Cumulative Inflation Rate Factor a Before-Tax Cash Inflows in Nominal Dollars
(1)
(2)
(3)
(4) (2) : (3)
1 $500,000 (1.10) 1 = 1.1000
$550,000
2 600,000 (1.10) 2 = 1.2100
726,000
3 600,000 (1.10) 3 = 1.3310
798,600
4 300,000 (1.10) 4 = 1.4641
439,230
a 1.10 = 1.00 + 0.10 inflation rate.
We continue to make the simplifying assumption that cash flows occur at the end of each year. The income tax rate is
40%. For tax purposes, the cost of the equipment will be depreciated using the straight-line method.
Exhibit 21-8 shows the calculation of NPV using cash flows in nominal dollars and using a nominal discount rate.
The calculations in Exhibit 21-8 include the net initial machine investment, annual after-tax cash flows from operations
Exhibit 21-8
Net Present Value Method Using Nominal Approach to Inflation for Network Communication’s
New Equipment
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
A B C D E F G H I J K L
Present Present Value
Value of Discount Factor a at
Sketch of Relevant Cash Flows at End of Each Year
Cash Flow 32% 0 1 2 3 4
1. Net initial investment
Year
0
Investment Outflows
$(750,000)
$(750,000) 1.000
$(750,000)
2a. Annual after-tax cash flow from
operations (excluding the depreciation effect)
Annual
Annual
Before-Tax Income After-Tax
Cash Flow Tax Cash Flow
Year from Operations Outflows from Operations
(1) (2) (3) = 0.40 x (2) (4) = (2) - (3)
1 $550,000 $220,000 $330,000 250,140 0.758
$330,000
2 726,000 290,400 435,600 250,034 0.574
$435,600
3 798,600 319,440 479,160 208,435 0.435
$479,160
4 439,230 175,692 263,538 86,704 0.329
$263,538
795,313
2b. Income tax cash savings from annual
depreciation deductions
Year Depreciation Tax Cash Savings
(1) (2) (3) = 0.40 x (2)
1 $187,500 b $75,000
56,850 0.758
$ 75,000
2 187,500
75,000
43,050 0.574
$ 75,000
3 187,500
75,000
32,625 0.435
$ 75,000
4 187,500 75,000 24,675 0.329
$ 75,000
157,200
NPV if new equipment purchased
$ 202,513
a The nominal discount rate of 32% is made up of the real rate of return of 20% and the inflation rate of 10% [(1 + 0.20) (1 + 1.10)] – 1 = 0.32.
b $750,000 ÷ 4 = $187,500