What factors would you use to decide whether to do you NPV analysis on real or a nominal basis
NPV analyses usually involves four steps such as forecasting the benefits and costs of a project in each year, determining a discount rate, using the NPV formula to calculate, and comparing the Net Present Value with other alternative projects. Comparing real (current) and nominal discount rates when conducting an analysis is all based on how detailed of an analysis you’re looking to obtain. Forecasting in real rates is much easier when doing an NPV analysis because it does not take into account inflation, whereas nominal rates still need to be discounted to real terms (PV). So fundamentally it is easier to conduct your analysis in real versus nominal because real will exclude inflationary factors.
Inflation plays a large role in factoring in on making an investment decision. One of the main aspects that impact an investment is inflation and the cost of financing an investment, therefore considering inflation in an analysis is usually always necessary to analyze cashflows. However, there are relationships that exclude the importance of inflation like accounting for the depreciation of the asset since the depreciation will usually be a straight line fixed amount over the course of a project. Another important factor to consider is that inflation considerations can be excluded when for example working with a long term supplier on a fixed price contract. Also, many times executives choose to exclude inflation in their analysis by using the argument that inflation can be reflected in the price that the producer charges for their goods and it can be adjusted.
The challenge that we face is that neither the SEC nor IRS accounting standards meet the requirements for making a real market decision that is based on what is actually occurring. Though the SEC accounting method will provide us with certain metrics to use in our analyses, it follows a general...
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