Effective rate of interest

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  • Profile photo of rimx

    Hi John,
    can you tell me under what circumstances we can use effective rate of interest for discounting for investment appraisal ?
    As with capital allowances it wont fluctuate with inflation so will they be calculated separately with actual discount rate ?
    Also, what the effects of general inflation be on the working capital and will effective rate of interest be feasible for it too to discount ?

    Profile photo of John Moffat
    John Moffat

    The only time you would discount at the real (or effective) rate in the exam would be if you had an inflating annuity over a long period, which is unlikely.

    ALmost certainly any project will be short (4 or 5 years) and you will calculate the nominal (actual) cash flows and discount at the nominal (actual) WACC.
    If you are given the real cost of capital then you use the formula on the formula sheet to get the nominal (actual) cost of capital).
    1 + actual cost of capital = (1 + real cost of capital) x (1 + general inflation rate)

    Working capital and capital allowances are not then any problem because you are discounting the actual cash flows.

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