NAME: AGAHIU SENUSI SAMSON

REG NO: 2001921013

COURSE: INVESTMENT AND PORTFOLIO MANAGEMENT
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 can occur in nearly any product or service, including need-based expenses
such as housing, food, medical care, and utilities, as well as want expenses, such as
cosmetics, automobiles, and jewelry. Once inflation becomes prevalent throughout an
economy, the expectation of further inflation becomes an overriding concern in the
consciousness of consumers and businesses alike.
What is inflation?

inflation is a measure of the rate of rising prices of goods and services in an economy. If
inflation is occurring, leading to higher prices for basic necessities such as food, it can
have a negative impact on society.

 Inflation is a measure of the rate of rising prices of goods and services in an

economy.
 Inflation can occur when prices rise due to increases in production costs, such
as raw materials and wages.
 A surge in demand for products and services can cause inflation as consumers
are willing to pay more for the product.
 Some companies reap the rewards of inflation if they can charge more for their
products as a result of the high demand for their goods

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DIFFERENCE BETWEEN MONEY INCOME AND REAL INCOME MONEY

Money income of a country is the amount of income (in monetary terms) earned by
factors of production excluding transfer payment in a given year or how of goods and
services produced in an economy.

However, money, as a medium of exchange, and a measuring device, has one major
disadvantage. This is the change in its size from time to time due to inflation in the
system. Hence, there is a difference between money income and real income.

1. Real Income is the basket of goods and services which the money income can
obtain.
2. In terms of the National Income, real national income is obtained by dividing
the money national income by the price index
3. Money flows depict the way that money and credit circulate in the economy as
income turns into savings and investment and back again.
4. Real flows depict the way that commodities and products & services are
produced and consumed in the economy.

DEFINITION OF CASH FLOW?

The term cash to most people refers to physical bills and coins. In consumer
transactions cash also refers to the physical bills and coins, better known as currency.
But the reality in economics is a bit different. Cash in economics is a form of liquid asset
that is listed on a company's balance sheet. Cash is essentially the money a company
has that can immediately be spent. Cash includes coins, bills, bank balances, money
orders, cashier checks and personal checks. So technically when a consumer swipes
their debt card at the store, they are using cash, since it comes from their bank account.

DEFINITION OF REAL FLOW

Real flow is when goods and services move from one sector of the economy to another
sector. Real flow is named so because there is the physical transfer of goods and
services amidst the two sectors, i.e. households and firms. Hence, it is also termed as
product flow or physical flow.

DIFFERENCE BETWEEN REAL FLOW AND MONEY/CASH FLOW

Let us understand the difference between real flow and money flow, in the elaborated
form:

1. Real flow involves the flow of factor services from the owners (households) to
producers (firms) and a corresponding flow of goods and services from the
producers (firms) to consumers (households). Conversely, we all know that flow
of factor services generates factor income, i.e. rent, wages, interest and profit,

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 from the firm to the households, and a corresponding flow of consumption
expenditure takes place from the household to the firm.
2. Real flow is also termed as physical flow because in real flow there is an actual
movement of goods and services between households and firms. On the
contrary, money flow is alternately known as nominal flow, because the
transactions take place, using money as a medium of exchange.
3. In case of real flow, the movement of factor services, and goods and services,
takes place in a clockwise direction, but in case of money flow, the movement is
reversed, and so the flow takes place in an anticlockwise direction.
4. Real flows involve the flow of factors of production, i.e land, labour, capital and
enterprise and in turn, the firms supply final goods and services to the consumers
so as to satisfy their demand. As against, in case of money flow remuneration is
provided to households by the firms for factor services in the form of rent for land,
wages for labour, interest for capital employed, and profit for enterprise and in
return, consumers spend the money to buy goods and services from the firms.
5. In a money flow, money is used as a medium of exchange, which facilitates
transactions, by valuing them in monetary terms. In contrast, in real flow money
is not used as a medium of exchange, rather physical flow of factors of
production and goods and services takes place. Therefore, the drawbacks of
the barter system may take place.

B CALCULATE MONEY AND DISCOUNT RATE

WHAT IS MONEY
Money, a commodity accepted by general consent as a medium of economic
exchange. It is the medium in which prices and values are expressed; as currency, it
circulates anonymously from person to person and country to country, thus facilitating
trade, and it is the principal measure of wealth.
REAL DISCOUNT RATE

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.

You can enter the nominal discount rate and the expected inflation rate in the
Economics page under the Projects tab. HOMER uses the following equation to
calculate the real discount rate:

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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).

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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
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. It will usually be either more or less than the percentage change
in other components. Sales price is market driven and we can’t just raise it without
incurring any loss.

3. 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)

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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.

Income Tax and Capital Budgeting Decisions:

1. Include income taxes in a capital budgeting analysis.

In our discussion of capital budgeting decisions in this chapter, we ignored income

taxes for two reasons. First, many organizations do not pay income taxes. Not-for-profit
organizations, such as hospitals and charitable foundations, and government agencies
are exempt from income taxes. Second, capital budgeting is complex and is best
absorbed in small doses.

The US income tax code is enormously complex. We only scratch the surface on this
page. To keep the subject within reasonable bounds, we have made many simplifying
assumptions about the tax code throughout this section. Among the most important of
these assumptions are :

1. Taxable income equals net income as computed for financial reports.

2. The tax rate is flat percentage of taxable income. The actual tax code is for more
complex than this; indeed, experts acknowledge that no one person knows or
can know it all. However, the simplifications that we make throughout this section
allow us to cover the most important implications of income taxes for capital
budgeting without getting bogged down in details

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CONCLUSION

With the above discussion, it is quite clear that real flows and money flows represents
two sides of the coin, wherein the real flow of goods and services is equivalent to the
same yet opposite money flow. Hence, goods and services flow in one direction and the
monetary payment to avail these services flow in the reverse direction.

REFERENCE
Abel, Andrew; Bernanke, Ben (2005). "Macroeconomics" (5th ed.). Pearson.
Measurement of inflation is discussed in Ch. 2, pp. 45–50; Money growth &
Inflation in Ch. 7, pp. 266–269; Keynesian business cycles and inflation in Ch. 9,
pp. 308–348.
Barro, Robert J. (1997). Macroeconomics. Cambridge, MA.: MIT Press. p. 895. ISBN 0-
262-02436-5.
Blanchard, Olivier (2000). Macroeconomics (2nd ed.). Englewood Cliffs, N.J.: Prentice
Hall. ISBN 0-13-013306-X.
Mankiw, N. Gregory (2002). "Macroeconomics" (5th ed.). Worth. Measurement of
inflation is discussed in Ch. 2, pp. 22–32; Money growth & Inflation in Ch. 4,
pp. 81–107; Keynesian business cycles and inflation in Ch. 9, pp. 238–255.
Hall, Robert E.; Taylor, John B. (1993). Macroeconomics. New York: W.W. Norton.
p. 637. ISBN 0-393-96307-1.
Burda, Michael C.; Wyplosz, Charles (1997). Macroeconomics: a European text. Oxford
[Oxfordshire]: Oxford University Press. ISBN 0-19-877468-0.