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A project is expected to earn $5000 per year (at current prices) in perpetuity, inflating at 4% per year.
The first receipt will be in one years time
The cost of capital is 12%.In order to get correct answer of 65000, you should take cost of capital of 12% as nominal rate.
Dear John, could you please explain, why cost of capital of 12% in this question is nominal rate and not real rate? I am bit confused.
Thank you.
To get the correct answer you certainly do not use a cost of capital of 12%!
You either discount the nominal cash flows at the nominal cost of capital, or alternatively you discount the current price cash flows at the real cost of capital.
Because it is a perpetuity, you have no choice in this case but to use the second approach.The real cost of capital is 1.12/1.04 – 1 = 0.0769231 (or 7.69231%)
Applying this to the current price flow of 5,000, gives a PV of 5,000 / 0.769231 = 65,000
The nominal cost of capital is the actual cost of capital and that is always what is given unless told differently.
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