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Hi,
I’m having trouble with regards to inflation and when to use the money/nominal rate and the real rate. I have a question currently where we’re looking at capital rationing and divisable and non-divisable projects. The money cost of capital of 12% is given and that is what I expected to use for the first two projects as I calculate their NPVs especially as the question makes sure to mention that the savings made etc are in money terms. The problem comes with the third project where we are told net cash savings of $120,000 per annum are expected in current terms and are expected to increase by 3.6% per annum due to inflation. Here the NPV was answered using the real rate. Is this because the savings are expected in current terms? But also wouldn’t we want to factor in inflation?
You have the choice of either inflating the flows and then discounting at the actual (nominal) cost of capital, or instead using the current price flows (without inflation) and discounting at the real cost of capital (without inflation).
Both will give the same answer – it does not matter which of the two approached you take.
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