Discount Rate: Nominal or Effective?

CFA Level I Corporate Finance
#1

Capital Budgeting

Is the discount rate used to discount cash flows an effective rate or a nominal rate?

#2

It depends on the nature of the cash flows.

You discount real cash flows with a real rate.

You discount nominal cash flows with a nominal rate.

#3

In practice: As under normal circumstances (except for rare cases of hiperinflation) you forecast nominal revenue, cost and cash flow streams (incl. inflation) your WACC (and its components) should be also nominal values. This is what you’ll see in 99% of the valuations in practice.

As S2000magician pointed out, there might be exceptions where you calculate your cash flows in real terms (excl. inflation). Then the WACC should be calculated as well in real terms. Regards,

Oscar

#4

OP: did you actually mean would the interest rate be compounded more than once a year (i.e. nominal) or real vs. nominal?

#5

nominal = incl. inflation real = nominal - inflation

#6

Okay. Thanks for clarifying that.

I had been using the TI BAII Plus Professional calculator’s ICONV function and there was a conversion feature to convert a nominal rate to an effective rate and vice-versa. That’s where my confusion stemmed from.

#7

Tell me more about that 1% of valuations where we will need to use real values. Who would use real values and why?

#8

This is the context under which I had asked my question.

#9

When your forecasts are in terms of Qnty, and multiplied with current price - that would count for a real value.

For eg. I’m valuing this company from Venezuala or Zimbabwe, I don;t want to dive into the complexity of dealing with inflation, deteriorating exchange rate and so on.

I thus stick with real cash flows and discount them with real rate.

#10

Real value is quantity multiplied by constant price… Current price would give you with inflation.