” • Back to basic “time-value” – The investor will lose the return he or she would earn in the best alternative investment (or, opportunity cost) – So, by discounting, the investor is accounting for this lost opportunity FIN 300 - Inflation 6
Now a World with Inflation • The investor has to account for losing something else (above and beyond the opportunity cost) – The investor will lose purchasing power – So, the investor (and we assume all investors in the market) will further discount the future cash- flow to account for this additional loss of purchasing power FIN 300 - Inflation 7
Now a World with Inflation • Our previous example, adjusted for inflation: FIN 300 - Inflation 8 PV “Real” discount rate (w/out inflation) Adjusting the CF to account for the loss of purchasing power - due to inflation 1y 0
Putting It All Together • It becomes obvious that in the presence of (the expectation of) inflation, investors in the market will discount for the risk that was present without inflation – plus the additional loss of purchasing power • So we have: FIN 300 - Inflation 9 We can adjust the numerator Or, alternatively, we can adjust the denominator
Nominal vs. Real Cash Flows • The cash flow (“CF”) in the previous slide is actually the “nominal” cash-flow – which is the actual dollars to be received in the future • Note that the correct PV (discounting for risk as well as inflation ) may be determined 2 different equivalent ways 1. Discount real (inflation-adjusted) CF by the real (inflation adjusted rate – or, rate that we had w/zero inflation) 2. Or, Discount the nominal (non-inflation adjusted) CF by the nominal (non inflation-adjusted) rate FIN 300 - Inflation 10
Nominal vs. Real Cash Flows
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