Economic assessment

1. Inflation
• Inflation is a phenomenon that results in decrease in purchasing
power and results in increases in costs.
• It affects estimates of future cash flows. In order to make better
decision, accurate capital budgeting calculations are important, which
are possible only when all the financial variables are taken care of.

2. Yield Calculations
• Uninflated cash flows is called real rate of return because it contains
no effects from inflation
• Inflated cash flows is called apparent rate of return; appear larger
than actually is due to inflation
• The relationship between real rate of return (ir), apparent rate of
return (ia) and the inflation rate (id);
(1+ia)=(1+ir)(1+id)

3. Yield Calculations
• Inflated (overstated)cash flows is called apparent rate of return (ia); appear
larger than actually is due to inflation
Nominal Discount Rate= (1 + Real Discount Rate)(1 + Inflation Rate) – 1
≈ Real Discount Rate + Inflation Rate
• Uninflated cash flow is called real rate of return (ir) after deduction of inflation
Real discount rate = (1 + nominal discount rate) ÷ (1+inflation rate) – 1
≈ nominal discount rate – inflation rate
• The relationship between real rate of return (ir), apparent rate of return (ia) and
the inflation rate (id); (1+ia)=(1+ir)(1+id)

4. Inflated cash flow-inflation 8%
Year C/F
PW factor
(10%) PW
PW factor
(8%) PW
0 -1,000 1 -1000 1 -1000
1 400 0.909 363.6 0.926 370.4
2 400 0.826 330.4 0.857 342.8
3 400 0.751 300.4 0.794 317.6
200 NPV -5.6 30.8
Interpolating between 8% and 10%= 9.69% (apparent rate of return-ia)
Formula (1+ia)=(1+ir)(1+id);
Real rate of return=1.5% <cost of capital (10%) reject the proposal
Calculate the apparent rate of return (ia) and real rate of return (ir) if the
inflation rate is 8%
You need to adjust your cash
flow

5. Uninflated cash flow
Interpolating between 10% and 26%
IRR (yield)=25.49% - apparent rate of return
Inflation rate 8%; Formula (1+ia)=(1+ir)(1+id);
IRR=16.19% (real rate of return)
Real rate of return=16.19%>10% (cost of capital); accept the project
Year C/F
PW factor
(10%) PW PW (26%) PW
0 -1,000 1 -1000 1 -1000
1 600 0.909 363.6 0.794 476.4
2 500 0.826 330.4 0.63 315
3 400 0.751 300.4 0.5 200
258.8 -8.6

6. Difference between IRR and ROI
• Net present value (NPV) is a technique that involves estimating future net cash
flows of an investment, discounting those cash flows using a discount rate
reflecting the risk level of the project and then subtracting the net initial outlay
from the present value of the net cash flows. It helps in identifying whether a
project adds value or not.
• There are a lot of different ways to measure investment performance, though
few metrics; among others the most popular are return on investment (ROI) and
internal rate of return (IRR).
• Across all kinds of investments, ROI is more common than IRR, largely
because IRR is more confusing and difficult to calculate.

7. Return on Investment: The Simple Yardstick
• Return on investment – sometimes called the rate of return (ROR) – is the percentage
increase or decrease of an investment over a set period of time.
• It is calculated by taking the difference between current (or expected) value and
original value, divided by original value and multiplied by 100.
• For example, suppose an investment was initially made at RM 100,000 and is now
worth RM 120,000 The equation for this ROI would be: (120,000 – 100,000) / 100,000)
x 100, or 20%. This calculation works for any time period.
120,000-100,000 X 100% =20%
100,000

8. IRR
• Back to the IRR: The IRR equals the discount rate that makes the NPV of future cash flows = zero.
It tells you what the annualized rate of return will be for a given investment – no matter how far
into the future – and a given expected future cash flow.
• For example, suppose your initial investment RM 100, 000 and the project will generate RM
40,000 in cash flows each year for three years. Interest rate is 10%
Year C/F
PW factor
(10%) PW PW factor (5%) PW
0 -100,000 1 -100,000 1 -100,000
1 40,000 0.909 36,360 0.952 38,080
2 40,000 0.826 33,040 0.907 36,280
3 40,000 0.751 30,040 0.864 34,560
-560 8,920
IRR =interpolating between 5% and 10%; IRR=9.70%;
This represents the average annual return over the 3 years of this investment. If the calculated
IRR is greater than or equal to cost of capital (10%), the investment looks like a good idea (at
least on paper). If not, the investment is probably not worth pursuing.

9. What is the difference between Yield and IRR?
The internal rate of return (IRR), or economic rate of return (ERR) on the other hand
is a method of calculating rate of return. The term internal refers to the fact that its
calculation exclude environmental factors (inflation , the cost of capital , or various
financial risks) . It is also called the discounted cash flow rate of return. In other
words, a return is retrospective, or backward-looking and describes what an
investment earned over a period.
Yield is defined as the income return on an investment. This refers to the interest or
dividends received from a security and is usually expressed annually as a percentage
based on the investment's cost, its current market value or its face value. Yield is
prospective, or forward-looking. It measures the income which includes the
environmental factors such as interest, dividends and inflation.

10. Quiz 18
• A project involves the initial capital investment of RM 100,000. It is expected that
following this investment the company will benefit from it by obtaining net cash
receipts of RM40,000; RM 40,000; RM 30,000 and RM 20,000 in each of the first 4
years of the project’s life respectively. Assume that these values are in money
terms as opposed to real terms which take into account the rate of inflation (3%
per annum);
a) What is the NPV for the project if the firm’s cost of capital is 12%.
c) Calculate real rate of return (yield) of these investments to the company.
d) Provide comments of your answer

11. Solution
Year C/F PW factor (12%) PW PW (15%) PW
0 -100,000 1 -100000 1 -100000
1 40,000 0.893 35720 0.87 34800
2 40,000 0.797 31880 0.756 30240
3 30,000 0.712 21360 0.658 19740
4 20,000 0.636 12720 0.572 11440
30,000 NPV=1680 NPV=-3780
Interpolation between 12% and 15%;
IRR=12.923% (apparent rate of return)
Inflation rate, 3%;
(1+ia)=(1+ir)(1+id);
real rate of return (yield) =9.63%<12%; reject the proposal;
the cash flow need to be adjusted

12. • END