Capital Investment & Inflation

The money rate of interest you need on an earn(or your Cost of capital) = 1+real rate of interest you want to earn(cost of paital in real terms(or Discount Rate) X 1+the expected inflation rate =(1.1016) = (1+1.02) X (1+1.08)

Nominal Cash Flow expressed in today's Money Real Cash Flow is discounted for Inflation Real Cash Flow 110 = Nominal Cash Flow121 / (1+0.1) in year 1 Yr 2 100 = 121/ (1+0.1)sq

so putting years 1 and 2 together and taking into account a Rate of Return (Cost of Capital)of 10% and an inf rate of 8% = 121*1.08/1.1x1.08 + 121*1.08sq/1.1sq*1.08sq - Initial investment of 100 = 11

Note that the infaltion is cancelled out because both the cost of capital AND the cash flows are subject to the same inflation rate so can be ignored If a different inflation rate was used for the cash flow and the cost of capital then the difference would be calculated.

This method used nominal cash flows and nominal discount rates

eg Real cost of K is 10% Inflows increase by 4% Outflows by 6% Inf is 5% So Inflows and outflows are affected by inf so we must show the real cost of K with inf = 15.5%