opportunity cost So by discounting the investor is accounting for this lost

# Opportunity cost so by discounting the investor is

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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 𝐶𝐶 1 + 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑜𝑖 𝑟𝑖𝑖𝑟 PV 𝑃𝑃 = 𝐶𝐶 1 + 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑜𝑖 𝑟𝑖𝑖𝑟 1 + 𝑖 “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 𝑃𝑃 = 𝐶𝐶 1 + 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑜𝑖 𝑟𝑖𝑖𝑟 1 + 𝑟𝑟𝑖𝑖 𝑟𝑖𝑖𝑟 = 𝐶𝐶 1 + 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑜𝑖 𝑟𝑖𝑖𝑟 1 + 𝑟𝑟𝑖𝑖 𝑟𝑖𝑖𝑟 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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• Fall '08
• Olander