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Dear Sir,
A silly question, what do we mean by taking in account of inflationary effect.
For Nominal rates we say inflation is incorporated, does this mean in nominal we have removed inflationary effect or its inflated amount in line with inflation?
What I think is…
Eg: I am getting 15% rate on my investments (This 15% is Nominal, Rate which is contracted on agreement it wont change)
If inflation is expected to be 5% (The real rate is now 10% this is what I will be getting in real terms and will change according with inflation)
Its so messed up!!
Regards
Usually we discount the nominal cash flows at the nominal cost of capital.
Nominal cash flows are the actual cash flows (adjusted for inflation). The nominal cost of capital is the actual cost of capital.Occasionally (but not very often) we discount the real cash flows at the real cost of capital. The real cash flows are the cash flows without adjusting for inflation. The real (or effective) cost of capital is the cost of capital with inflation removed.
The return you are getting on investments is not relevant – it is the cost of capital that is relevant.
If the nominal cost of capital is 15% and the inflation is 5% then the real rate is not 10%. It is 1.15/1.05 – 1 = 0.0952 or 9.52% (the formula is given on the formula sheet).All of this is dealt with in the free lectures on investment appraisal.
So if I got it right so the logic is like this…
Nominal Cash flows are future cash flows involving inflationary increases, So we use Nominal rate (again rate which incorporate inflation rate)
Real Cash flows do not include inflation and are normal current flows at constant price levels here we use real rate.
In case we have to use real rates… then we remove inflationary effect (if they are in nominal cash flows) and then apply real rate..
I hope I got it right !
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