Question

Q1. What effect does inflation have on discount factors?

Answer 1

Inflation and interest are closely related. It was noted in the last chapter that interest rates should generally cover more thaninflation. In fact, the amount of interest earned over inflation is the only real reward for aninvestment. Consider an investment of $1,000 that earns 4% over a one-year period, andassume that during that year the inflation rate is also 4%. At the end of the year, the investorreceives $1,040. Has the investor gained anything from this investment? On the surface, hehas earned $40, so it seems like he has. However, because of inflation, the purchasing powerof the $1,040 that he now has is the same as the purchasing power that the initial investmentof $1,000 would have had a year earlier. Essentially, the investor has earned nothing. In thiscase, we would say that the real rate of return, the rate of return after inflation, was zero.

The rate of interest that is earned in excess of the inflation rate is this price of money. This rate, called the real interest rate, is determined by the balance between the demand formoney to borrow and the supply of money from lenders. Even without inflation it would stillbe necessary to charge interest to achieve a balance in the market for money. In a world withinflation, the interest rate must cover both inflation and the cost of capital.

The nominal interest rate (sometimes simply called the nominal rate) is theinterest rate that is quoted by banks, credit cards, stock brokers, etc. Thenominal rate includes both the cost of capital and inflation. It is the rate that isused to discount actual, inflated future values.Part of the nominal interest rate goes to cover inflation, and the rest is what is “really” earnedon 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 capitalinvestment after accounting for inflation. Inflation has been removed from thereal interest rate. The real interest rate should be used to discount futurevalues that are expressed in current dollar values.

There are sometimes good reasons to include inflation. For example:

• Different cost types e.g. labour and materials may attract different inflation rates.
• If tax reliefs or credits are significant and offset from the timing of their associated costs or benefits, they would be affected by a rate of inflation associated with one period, but would need to be discounted at rate associated with another period.

When inflation is included in project models, its effects are usually calculated with standard rates that represent the organisation's estimate of what inflation. These calculations are then used to transform estimates that have been made at today's rates. When modelling on this basis, it is important to recognises that inflation has a compound effect.