3.9. Discount rates – nominal and real. The role of inflation

Well, it's time now to talk about discount rates.

Well, the key story here is that in the analysis of NPV,

you have to properly treat, Inflation.

Well, the general idea is as follows.

So for one period, we can have the formula

that says that 1 + r nominal,

Is equal to, well, I shouldn't have put here brackets, but whatever.

It's 1 + r real,

Times, let me use the black marker,

1 + i, where i is the expected inflation rate here.

We are now sort of invading the area of macroeconomics, too.

But for us, the key story is that if there is inflation,

then if this inflation would be linked to our components

of cash flows in a uniform way, we would not care much.

We could say, well, we analyze cash flows on a nominal or

on a real basis and we don't care.

But the problem is that our nominal components,

Of cash flow, and their real components.

So if we talk about depreciation, for example, this is not nominal.

So equipment maybe depreciate over a long period of time.

And this period may be associated with high inflation.

But that by no means affects

the depreciation charges over the useful life of the equipment.

When it comes to cash components, let's say fuel,

labor, then in this case they are sort of more real.

And by real we mean not artificial,

but real in terms of treatment of the rates.

Because basically,

if there is high inflation this is very much likely than labor or

products or other things will also become more expensive.

And it's better to treat them as real.

If you talked about special components of cost ceiling,

we have commodity prices, for example.

That creates another huge problem because you know that most of the prices for,

let's say gasoline or some other kinds of fuels that people or

companies use, they're sort of based on the market prices for

commodities that are quite volatile and

over long periods of time may change drastically.

So that introduces yet another dimension of uncertainty.

But that can hardly be dealt with using this most simplistic treatment.

Now, strictly speaking, we know that these

rates, they're taken from the yield curve and

the expectations that are observed on bond markets.

So, again, all the rates that they extracted from the analysis of bonds,

they are nominal.

But the inflation rates, they are expected with

some very specific level of certainty.

And oftentimes, you have to be careful because normally the inflation

rate is taken only as dynamics of the CPI index.

And, for example, in recent years, we've seen very low inflation rates

in the most developed countries in this consumer sector that

was associated by the very fast

growth of prices in commodities and financial instruments.

So sort of inflation was observed in the area of assets,

not in the area of consumer prices.

So here you really have to be careful, but

that goes a little bit beyond the scope of our course.

We just have to make sure that if these forecasts exist,

they must be properly taken into count.

And the most important piece for us is this treatment in a consistent way.

So basically we either discount the nominal components at the nominal rate,

real components at the real rate.

Or we artificially blow up,

let's say, real components at the level of inflation and

then take a uniform approach of the application of the nominal rate.

All that is, again, I would not really talk about that.

It's very easy to see on examples and on problems.

And that's exactly what we will be doing in the remainder of this week and

also what you'll be doing on your assignments too this week.

3.9. Discount rates – nominal and real. The role of inflation

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