ActSc371_Lecture 20_Chapter 8 (Ross) - part 2

ActSc371_Lecture 20_Chapter 8 (Ross) - part 2 - ActSc 371...

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Lecture 20 Chapter 8 Cont’d: NPV and Captial Budgeting (Corporate Finance by Ross et al.) ActSc 371 – Corporate Finance 1 Instructor: Dr. Lysa Porth 1
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Inflation and Capital Budgeting Inflation is an important fact of economic life and must be considered in capital budgeting. Consider the relationship between interest rates and inflation, often referred to as the Fisher relationship: (1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate) For low rates of inflation, this is often approximated as Real Rate  Nominal Rate – Inflation Rate While the nominal rate in the U.S. has fluctuated with inflation, most of the time the real rate has exhibited far less variance than the nominal rate. Consistency: When accounting for inflation in capital budgeting, one must compare real cash flows discounted at real rates or nominal cash flows discounted at nominal rates.
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Example of Inflation Assume inflation of 6% over the year and it affects all goods equally, and that financial institutions pay a 10% return. A restaurant charges $1.00 for a hamburger at date 0, charges $1.06 for the same hamburger at the end of the year. If you have $1,000: You can buy 1000 hamburgers today You can put your 1000 in the bank and have 1100 at the end of the year. Then, you can buy 1038 hamburgers at the end of the year. Result: you can increase your hamburger consumption by
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ActSc371_Lecture 20_Chapter 8 (Ross) - part 2 - ActSc 371...

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