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Investment appraisal – Further aspects of discounted cash flows

The impact of inflation

1.1 The impact of inflation on interest rates (discount rates)

Inflation is a general increase in prices leading to a general decline in
the real value of money.

In times of inflation, the funding providers will require a return made up of two
elements:

 a real return for the use of their funds (i.e. the return they would want if there
were no inflation in the economy)

 an additional return to compensate for inflation (so that they don’t lose out from
the effects of inflation)

 the overall return required from these two elements is called the money or
nominal rate of return

The real and money (nominal) returns are linked by the formula:

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

Where r = real rate of return h = inflation rate

i = money cost of capital (the company’s normal cost of capital)

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