Nominal Cost of Capital

CFA Level II Corporate Finance
#1

Hey AF

In a Mock Exam from Kaplan the following information is stated:

" GigaTech has estimated real capital costs for the two projects at 10.58%. GigaTech expects inflation to be approximately 4.0% for the foreseeable future."

It seemed as you would just add the real capital costs with the approx. inflation to get 14.58%.

However, Kaplan multiplies the two in the solution as 15.0% = (1 + 0.1058)(1 + 0.04).

Why not just add them?

Kind regards,
Christoffer

#2

Adding them is an approximation; compounding them is accurate. Inflation affects the purchasing power of both the initial investment and the return on investment.

1 Like
#3

Thank you - much appreciated!

#4

My pleasure.