Forecast sales volume is 300,000 units per year, increasing by 50,000 units per year, and the investment project is expected to last for four years.

Inflated selling prices

Year 1: 5.30 x 1.05 = $5.57 per unit

Year 2: 5.30 x 1.05^{2} = $5.84 per unit

Year 3: 5.30 x 1.05^{3} = $6.14 per unit

Year 4: 5.30 x 1.05^{4} = $6.44 per unit

Inflated sales revenue

Year 1: 5.57 x 300,000 = $1,671,000

Year 2: 5.84 x 350,000 = $2,044,000

Year 3: 6.14 x 400,000 = $2,456,000

Year 4: 6.44 x 450,000 = $2,898,000

Inflated variable costs

Year 1: 3.15 x 1.04 = $3.28 per unit

Year 2: 3.15 x 1.04^{2} = $3.41 per unit

Year 3: 3.15 x 1.04^{3} = $3.54 per unit

Year 4: 3.15 x 1.04^{4} = $3.69 per unit

Using year 2 inflated costs as an example, when performing these calculations in a spreadsheet the following methods can be used

=3.15*1.04^2

=3.15*POWER(1.04,2)

There are other methods of calculating these figures and any approach which gives the correct figures will be given credit in the exam.

Inflated total variable cost

Year 1: 3.28 x 300,000 = $984,000

Year 2: 3.41 x 350,000 = $1,193,500

Year 3: 3.54 x 400,000 = $1,416,000

Year 4: 3.69 x 450,000 = $1,660,500

Nominal terms total contribution

Year 1: 1,671,000 – 984,000 = $687,000

Year 2: 2,044,000 – 1,193,500 = $850,500

Year 3: 2,456,000 – 1,416,000 = $1,040,000

Year 4: 2,898,000 – 1,660,500 = $1,237,500

#### Real cash flows

Real cash flows are found by deflating nominal cash flows by the general rate of inflation.

**Example of calculating real cash flows by deflating nominal cash flows**

Using the nominal cash flows calculated above and a general rate of inflation of 4.8%:

Real terms total contribution

Year 1: 687,000/ 1.048 = $655,534

Year 2: 850,500/ 1.048^{2} = $774,376

Year 3: 1,040,000/ 1.048^{3} =$903,544

Year 4: 1,237,500/ 1.048^{4} = $1,025,888

#### Nominal terms approach to investment appraisal

The nominal terms approach to investment appraisal involves discounting nominal cash flows with a nominal cost of capital in calculating the NPV of an investment project.

**Example of calculating nominal terms NPV**

Using the nominal contributions calculated earlier, a nominal discount rate of 9.0% and an assumed initial investment of $1,000,000: