Capital Budgeting - Real Vs Nominal Interest Rates

The real interest rate represents the true cost of borrowing or the real return on investment after removing the effect of inflation. In contrast, the nominal interest rate is the stated or market rate that includes inflation. The relationship between them is given by the Fisher equation:
(1 + nominal rate) = (1 + real rate) × (1 + inflation rate).
In simple terms, the real rate ≈ nominal rate – inflation rate. Real rates reflect actual purchasing power, while nominal rates show money growth. Understanding both helps investors and policymakers assess true returns, economic growth, and monetary policy effectiveness.

1. Real Vs Nominal Interest Rates

2. Inflation affects both cash flows and the discount rate . If inflation is ignored, the project’s Net Present Value (NPV) may be either overstated or understated. To handle inflation properly, you must match the type of cash flows with the correct discount rate. Inflation in Capital Budgeting

3. Suppose a person—we call him Jose, deposits Rs . 100 in the State Bank of India for one year at 10 per cent rate of interest. This means that the bank agrees to return Rs . 110 to Jose after a year, irrespective of how much goods or services this money can buy for him. The sum of Rs . 110 is stated in nominal terms —the impact of inflation not separated. Thus, 10 per cent is a nominal rate of return on Jose’s investment. Let us assume that the rate of inflation is expected to be 7 per cent next year. What does the rate of inflation imply? It means that prices prevailing today will rise by 7 per cent next year. In other words, a 7 per cent rate of inflation implies that what can be bought for Re 1 now can be bought for Rs.1.07 next year. We can thus say that the purchasing power of Rs.1.07 next year is the same as that of Rs.1.00 today. What is the purchasing power of Rs.110 received next year? It is `110/1.07 = `102.80; that is, the `110 received next year can buy goods worth `102.80 now. Concept

4. The `110 next year and `102.80 today are equivalent in terms of the purchasing power if the rate of inflation is 7 per cent. The Rs.110 is expressed in nominal terms since they have not been adjusted for the effect of inflation. On the other hand, the Rs.102.80 are in real terms since they have been adjusted for the effect of inflation. Our investor, Jose, thus earns, 10 per cent nominal rate of return, but only 2.8 per cent real rate of return. It should be noted that the rate of inflation is an expected rate; therefore, the real rate of return is also expected. The actual rate of inflation may be different from the expected rate. The opportunity cost of capital of a firm or project is generally market determined and is based on expected future returns. It is, therefore, usually expressed in nominal terms and reflects the expected rate of inflation. The opportunity cost of capital or the discount rate is a combination of the real rate (say, K) and the expected inflation rate (let us call it, alpha). This relationship, long ago recognised in the economic theory, is called the Fisher’s effect.

5. If a firm expects a 10 per cent real rate of return from an investment project under consideration and the expected inflation rate is 7 per cent, the nominal required rate of return on the project would be: k=( In practice, it is customary to add the real rate and the expected inflation rate to obtain the nominal required rate of return: k = K + a. Nominal discount rate can be used to derive the real rate of return (K): It may be stated as follows:

6. Suppose a firm is considering a project with the following cash flows, on the assumption that prices and costs increase at the same rate, the firm follows the practice of stating cash flows at the prices of period zero. Example

7. This means that cash flows are expressed in real terms. The firm’s opportunity cost of capital, which is market determined and is expressed in nominal terms, is 14 per cent. Can the project’s real cash flows be discounted at the 14% nominal rate of discount? Clearly the answer is no! It would be inconsistent to discount the real cash flows of the project by the nominal discount rate. If we do so, the NVP of the project, as calculated below, will be biased: The project shows a negative NPV and, therefore, would be rejected. But a bias has entered into the analysis. The cash flows are in real terms while the discount rate is in nominal terms. For a correct analysis, two alternatives are available: either the cash flows should be converted into nominal terms and then discounted at the nominal required rate of return or the discount rate should be converted into real terms and used to discount the real cash flows.

8. Let us assume that in our example the rate of inflation is expected to be 7 per cent. Thus, the cash flows in nominal terms will be: Alternatively, we can find out the real discount rate and discount the cash flows without converting them into nominal terms. The real discount rate will be:

9. Notice that the results under both alternatives are same. The project’s NPV is positive, so accept it. Always remember: Discount nominal cash flows at nominal discount rate; or discount real cash flows at real discount rate. The NPV formula can be written as follows when cash flows and discount rates are expressed in nominal terms: where K is the real discount rate, α is the expected inflation rate and Ct is the series of real cash flows, using Equation (5) in the example, we get:

10. Thus it is obvious that when the expected inflation rate is properly reflected in the cash flow estimates and the discount rate, the resulting NPV is stated both in real and nominal terms,7 and it is free of inflation bias. Since the inflation factor in the numerator and denominator of Equation (15) is same, the formula becomes:

11. Two Types of Values Type Description Includes Inflation? Nominal (or Money) values Actual rupees expected to be received/spent in the future ❌ No Real values Expressed in today’s purchasing power (adjusted for inflation) ✅ Yes

12. Two Types of Discount Rates Type Formula Used With Nominal Discount Rate (i) Reflects both real return and inflation Nominal Cash Flows Real Discount Rate (r) Reflects only the real rate of return (excluding inflation) Real Cash Flows

13. Brigham, Eugene F. & Ehrhardt, Michael C. – Financial Management: Theory and Practice Reference