Hello Anu, and good to hear from you again!
The question tells us that ‘product recall costs have deflated at 2% per annum over Years 4 and 5, with
no inflation prior to that.’
In other words, we have:
- zero inflation until the last day of Year 3, then
- a sudden step change to deflation the next day, at the start of Year 4.
So, if we make the normal assumption that inflation (or deflation in this case) applies midway through Year 4 on average, then Year 3 will need only an extra half years’-worth of inflation compared to Year 4. And of course, the inflation adjustment for Years 1 and 2 will be the same as for Year 3.
As it happens, the examiners would have allowed an alternative approach whereby the inflation adjustment for Years 1 to 3 was the same as for Year 4.
As always, the moral of the story is to use the detail in the question and state appropriate assumptions.
Best wishes,
Katherine.
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