Explain the two techniques (real rate adjustment and using nominal cash flows) to account for inflation...

Explain the two techniques (real rate adjustment and using nominal cash flows) to account for inflation in capital budgeting, briefly.

Expert Solution

The nominal interest rate (sometimes simply called the nominal rate) is the interest rate that is quoted by banks, credit cards, stock brokers, etc. The nominal rate includes both the cost of capital and inflation. It is the rate that is used to discount actual, inflated future values.
Part of the nominal interest rate goes to cover inflation, and the rest is what is “really” earned on an investment. What is left over after inflation is called the real interest rate.
The real interest rate (also called the real rate) is the rate earned on a capital investment after accounting for inflation. Inflation has been removed from the
real interest rate. The real interest rate should be used to discount future values that are expressed in current dollar values.
A nominal interest rate can be broken out into two components: the inflation rate and the real
interest rate. That is,
the nominal rate =the inflation rate + the real rate.

ekkarill92 answered 2 years ago

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