Making Capital Investment Decisions. Explain the use of real and nominal discount rates in discounting cash flows. Which is used more often and why?
Real Discount Rates
A real interest rate is the interest rate that takes inflation into account. This means it adjusts for inflation and gives the real rate of a bond or loan. To calculate the real interest rate, you first need the nominal interest rate. The calculation used to find the real interest rate is the nominal interest rate minus the actual or expected inflation rate.
Suppose a bank loans a person $200,000 to purchase a house at a rate of 3%—the nominal interest rate not factoring in inflation. Assume the inflation rate is 2%. The real interest rate the borrower is paying is 1%. The real interest rate the bank is receiving is 1%. That means the purchasing power of the bank only increases by 1%.
The real interest rate gives lenders and investors an idea of the real rate they receive after factoring in inflation. This also gives them a better idea of the rate at which their purchasing power increases or decreases. They can estimate their real rate of return by comparing the difference between a treasury bond yield and a Treasury Inflation Protected Securities(TIPS) yield of the same maturity, which estimates inflation expectations in the economy.
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