The two rates of return and the inflation rate are linked by the equation, (1 + i) = (1 + r)(1 + h)
where all rates are expressed as proportions.
(1 + 0.2) = (1 + r)(1 + 0.1)
1 + r = 1.2 / 1.1 = 1.091
r= 9.1%
Part 2: Do we use the real rate or the nominal rate?
The rule is as follows.
(a) If the cash flows are expressed in terms of the
actual number of dollars
that will be
received or paid
on the various future dates
, we use the
nominal rate for discounting
.
(b) If the cash flows are expressed in terms of the
value of the dollar at time 0
(that is, in
constant price level terms), we use
the real rate
.

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IPK COLLEGE
1664, JALAN KULIM, 14202 BUKIT MERTAJAM, PENANG
TEL : 012-5203212 / 0125113212 / 04-5512588
Subject: Financial Management
(DFM1)
Prepared by Susan Lim
Email : [email protected]
The cash flows given above are expressed in terms of the actual number of dollars that will be
received or paid at the relevant dates (nominal cash flows). We should, therefore, discount
them using the nominal rate of return.
Time
Cash flow ($)
Discount factor 20%
PV ($)
0
(15,000)
1
9,000
2
8,000
3
7,000
The project has a positive net present value of $_______.
The future cash flows can be expressed in terms of the value of the dollar at time 0 as follows,
given inflation at 10% a year.
Time
Cash flow ($)
Cash flow at time 0 price level
0
(15,000)
1
9,000
2
8,000
3
7,000
The cash flows expressed in terms of the value of the dollar at time 0 (real cash flows) can now
be discounted using the real rate of 9.1%.
Time
Cash flow ($)
Discount factor 9.1%
PV ($)
0
(15,000)
1
9,000
2
8,000
3
7,000

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Page
4
of
13
IPK COLLEGE
1664, JALAN KULIM, 14202 BUKIT MERTAJAM, PENANG
TEL : 012-5203212 / 0125113212 / 04-5512588
Subject: Financial Management
(DFM1)
Prepared by Susan Lim
Email : [email protected]
Part 3: The advantages and misuses of real values and a real rate of return
(1)
Generally the 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.
Cost and benefits which inflate at different rates
(1)
Not all costs and 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
.
Example: Inflation
Rice is considering a project which would cost $5,000 now. The annual benefits, for four years,
would be a fixed income of $2,500 a year, plus other savings of $500 a year in year 1, rising by
5% each year because of inflation. Running costs will be $1,000 in the first year, but would
increase at 10% each year because of inflating labour costs. The general rate of inflation is
expected to be 7½% and the company's required nominal rate of return is 16%. Is the project

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- Spring '17
- JANE KDAL