Allowing for inflation
As the inflation rate increases so will the minimum return required by an investor
The nominal interest rate incorporates inflation.
When the nominal rate of interest > rate of inflation = positive real rate. When the rate of inflation > nominal rate of interest = negative real rate.
The relationship between real and nominal rates of interest is given by the Fisher formula:
1.2 Do we use the real rate or the nominal rate?
The rule is as follows.
a) If cash flows expressed actual number of dollars that will be received/paid on the various future dates, we use the nominal rate for discounting. b) If cash flows expressed in terms of the value of the dollar at time 0 (that is, in constant price level terms), we use the real rate.
1.3 The advantages and misuses of real values and a real rate of return Although generally companies should discount money values at the nominal cost of capital, there are some advantages of using real values discounted at a real cost of capital.
a) When all costs and benefits rise at the same rate of price inflation, real values are the same as current day values, so that no further adjustments need be made to cash flows before discounting. In contrast, when nominal values are discounted at the nominal cost of capital, the prices in future years must be calculated before discounting can begin. b) The government might prefer to set a real return as a target for investments, as being more suitable than a commercial money rate of return.
1.3.1 Costs and benefits which inflate at different rates
Not all costs/benefits will rise in line with the general level of inflation. In such cases, we can apply the nominal rate to inflated values to determine a project's NPV.
1.6 Expectations of inflation and the effects of inflation
When managers/shareholders evaluate their investments, they can only guess at what the rate of inflation is going...