Question

1. Explain how the Valuation Principle applied when using present value and future value calculations?

2. When using Nominal Rates to discount future cash flows your answer is incorrect because it does not include inflation. True or False.

Answer 1

Hi,

Ques 1:-

Valuation principle applied when using Present value and future value calculations is Time Value of Money. Simply, the money today is worth more than the same money tomorrow because of the passage of time then value of money decreases. So for this we apply discount rate which decreses the value in case of calculating Future value of money and increases the value of money in case of calcualtion of Present value of money (Because Present value of one dollar is more than it's future value). The formula for Present value and future value is :-

Where, r = Discount Rate

t = time

Present Value gives the discounted future cash flows and future value gives the compounded future cash flows.

Ques 2:-

This statement is False. Nominal Discount rate is the rate which includes the effect of inflation. It is Real Discount Rate which doesnot include effect of inflation. So, Nominal discount rate include the effect of inflation which is based on consumer Price Index(CPI) or GDP Deflator. Hence, if we use Nominal rate to discount future cash flows then we will get correct answer instead if we use real rate to discount future cash flow then we will get wrong answer. So, this statement is true.

Thanks!