ACCA F9 - something I don't understand...

ACCA F9 - something I don't understand...

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I am a student studying for ACCA F9.
I am doing a question on discounting of free cash flows (FCF).

The question says a FCF of £42m grows at 3% for the next 15 years, and I am supposed to discount it to present value.

The answer guide says, that although the FCF is growing at 3% in nominal terms, it is constant in real terms.
It then proceeds to use the Fisher equation, using 3% as inflation, and 11% as cost of equity => gives 8% as discount rate, and then uses annuity factor to discount given this FCF is now constant.

What i don't understand, is how can a cash flow be constant in real terms?
I would never have thought to do the above from the information that was provided in the question.
If it explicitly says that the FCF is growing at 3%, then how can this be deduced?

Any insight from someone clever would be most appreciated.

Replies (5)

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By johngroganjga
26th Apr 2014 21:26

Real terms usually just means net of inflation.

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By Abacus Finch
27th Apr 2014 11:04

I guess maybe the question should have made it clear that the growth in FCF is 3%, and that for calculation purposes the assumed rate for inflation is also 3%, essentially leaving the annual FCF constant in real terms, rather than give you the inflation figure in the answer. I suppose adjusting the cash flows for inflation before discounting means the discount rate can ignore inflation? I prefer to add the risk free rate to the cost of equity, then use a weighted average of this with the cost of debt (if there is any debt) as the discount factor, but then I don't set the questions!

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By MDK45
27th Apr 2014 16:42

A cash flow can be constant in real terms but increasing in nominal terms. In this case inflation is 3 per cent and fcf is growing at 3 per cent but value is maintained. These questions normally intermix the terms 'real' and 'nominal' to test our understanding on how to ascertain value after we strip out inflationary effects.

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By humshah
27th Apr 2014 18:20

Yes but...
I understand that the FCF was growing nominally at 3%.
If i was told explicitly that inflation was also 3%, then naturally i would have deduced that the cashflow was constant in real terms.
The context of the question doesn't say anything about inflation being 3% also, so how am i supposed to know?

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By johngroganjga
27th Apr 2014 20:00

Perhaps you were supposed to deduce it from the fact that the money rate of return was 3% and the real rate was 0%.

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