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Investment appraisal

2.3 Which cost of capital should be used?

Two key considerations:

 if the FCF have been inflated into nominal terms, the nominal cost
of capital should be used.

The nominal cost of capital (i) and the real cost of capital (r) are
linked by the Fisher formula:

(1+i) = (1+r)(1+h)

where h is the general rate of inflation in the economy.

Alternatively, if the FCF are not inflated (stated in current terms)
the inflation-adjusted real rate can be used as a discount rate.

 the cost of capital must reflect the risk of the project being
appraised. This issue is covered in more detail in later Chapters 6
and 7.

Illustrations and further practice

Now try TYU 1 and TYU 2 from Chapter 2

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