Hi there
I am stuck in solving a problem where it was asked to calculate the nominal rate given an initial investment, future cash flows (3 years), the required rate (real rate) and inflation.
no problem with this but there is an additional question where it is being asked to calculate the IRR of this investment.
Does the calculation only account the future cash flows at nominal value without disregarding the inflation or I should take inflation into the IRR calculation ?
Thank you in advance!
I think it will be better if you shared the problem itself.
sure, here it is
Initial investment: 2,000,000 USD
Cash flow year 1: 1,650,000 USD
cash flow year 2: 2,100,000 USD
cash flow year 3: 2,450,000 USD
knowing that inflation is 4% and real rate is 10%, what is the IRR for this investment?
I think you misunderstood … the required is the IRR which is the discount rate at which the present value of future cash flows equals the Initial investment… In other words, the rate at which the NPV of the project equals Zero.
You can easily find it using the financial calculator which will be around 79.2% (Given the information in your example, which is kind of ridculus because no real investment provide such return)
Notice
we didn’t talk about the required rate of return (which is determined by the market) and it will be (the real rate + Inflation Premium) assuming there is no risk premium for the project (per your example) so the required rate of return should be 14% and it can be used to determine the NPV of the project to be $2,716,930.446
Thanks
Yes, I also find the IRR quite high but those were the figures from my exercise.
the 14% required rate of return is basically the nominal rate, correct?
If those are nominal cash flows then the required rate of return is likely given as a nominal return; if those are real cash flows then the required rate of return is likely given as a real return.
yes
Nominal means including the inflation premium
Real means without considering inflation
The nominal rate is 14% which mean if you invested $100 you get $14 as return … but looking at the economy you might notice that prices actually increases due to inflation so th $14 you got is not worth the same when you invested your money and they actually worth $10 at the time you invested the money which means that you real return is 10%
and @S2000magician knows better than me so he can correct me if I am wrong
either my finance book is wrong, or you got it backwards.
Nominal rate = Real Rate + Inflation Premium
Nominal Rate is the actual rate paid and received between parties.
I meant Real Return doesn’t consider Inflation Premium … they simply take inflation out and focus on the REAL value you get
I hope I didn’t cause confusion
When do you add the nominal and the real rate versus (1+infla)(1+real)?
When you want to approximate.
When you want to do it correctly.
Thank you!