Question 7.2: Explain the difference between the nominal-terms approach an...
Explain the difference between the nominal-terms approach and the real-terms approach to dealing with inflation in investment appraisal.
The real cost of capital can be found by deflating the nominal (or money terms) cost of capital. Nominal project cash flows can be obtained by inflating estimated cash flows to take account of inflation which is specific to particular costs and revenues. Real project cash flows can be obtained by deflating nominal project cash flows to take account of general inflation. The NPV of the project can then be found either by discounting nominal cash flows by the nominal cost of capital (the nominal or money terms approach) or by discounting real cash flows by the real cost of capital (the real terms approach). The NPV will have the same value whichever method is used.