Financial Management: Principles and Applications, 13/e

12.3 Inflation and Capital Budgeting

Because investments are expected to provide cash flows over many years, we cannot overlook the issue of inflation. Fortunately, we can adjust project revenues and expenses for the anticipated effects of inflation. Cash flows that account for future inflation are generally referred to as nominal cash flows. Sometimes analysts calculate what we refer to as real cash flows, which are the cash flows that would occur in the absence of inflation.

When nominal cash flows are used, they should be discounted at the nominal interest rate, which you can recall from Chapter 9 as the rate that we observe in the financial markets. In most cases, firms do use nominal rates of return for the discount rates that are used to ...