Question
I am working on Victoria Chemicals/Diamond Chemicals case and am, trying to understand how to update the DCF model to account for the following comments:
I am working on Victoria Chemicals/Diamond Chemicals case and am, trying to understand how to update the DCF model to account for the following comments: Currently the DCF accounts for inflation of 0% and a discount rate of 10%. I am supposed tp updated the DCF to account for the following conversation:
After a meeting on a different matter, Greystock described his dilemmas to Andrew Gowan, who worked as an analyst on Diamond Chemicals' Treasury staff. Gowan scanned Greystock's analysis and pointed out: Cash flows and discount rate need to be consistent in their assumptions about inflation. The 10% hurdle rate you're using is a nominal target rate of return. The Treasury staff thinks this impounds a long-term
inflation expectation of 3% per year. Thus Diamond's real (that is, zero inflation) target rate of return is
7%. The conversation was interrupted before Greystock could gain a full understanding of Gowan's comment. For the time being, Greystock decided to continue to use a discount rate of 10% because it was the figure promoted in the latest edition of Diamond Chemicals' capital-budgeting manual.
My Question is:
1) Should inflation be 3% and discount rate 7% in my model
2) Should inflation stay at 0% and discount rate 10% in my model
3) Should inflation be 3% and discount be 10%.
The internet says consistency should be used. Either use nominal numbers for both or real numbers for both but this is confusing me because it says the result should be the same.
The results in NPV are not the same when I use 0% inflation and 10% discount which I understand to be the nominal rates and when I use what I understand to be real rate of 3%. inflation and 7% discount rate. These do not yield the same NPV?
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