Handling Inflation in Net Present Value

Net present value is computed to evaluate the investment options compare them with each other so as to make a prudent choice of investment. The net present value is computed by deducting the present value of cash outflows from the present value of cash inflows. The present value of cash outflows and inflows is computed by discounting the cash flows with the appropriate rate of discount. Here, the issue arises as to the use of the discount rate that whether it would be inflation adjusted or not. This issue is the main theme of the discussion in this paper and provides the finance assignment help in handing the inflation in the net present value calculations. 

Essay writers state that there are two types of interest rates, such as nominal and real, which can be used for discounting the cash flows in the computation of the net present value. The real interest rate is nothing but just the nominal interest rate adjusted for inflation. The financial accounting assignment help reveals that when the cash flows are discounted to their present value, the inflation does not play any role because value of future cash flows is brought equivalent to the dollar value as of today. Thus, it should be remembered that in discounting the cash flows adjusted for inflation, the discount rate adjusted for inflation is used. This implies that the real cash flows should be discounted with real interest rate and the nominal cash flows with the nominal interest rate. 

From the finance homework help online, an example has been extracted, where the real cash inflow of $1,000, the real rate of interest 10%, and inflation is 5%. The present value for one year from today using real discount rate can be arrived at as under:

Real cash inflow = $1,000       

Real rate of interest = 10%

Inflation = 5%

Present value = $1000/ (1+10%) ^1

= $909.09

In the above example, it can be observed that the real cash flows have been discounted using the real interest rate. The net present value works out to be $909.09 under this method. Now we apply another method to compute the net present value in the above example:

Nominal cash inflow = $1,000*(1+5%)

= $1,050       

Nominal rate of interest = 10 %*( 1+5%)

= 15.50%

Present value = $1,050/ (1+15.5%) ^1

= $909.09

In both the examples, it can be observed that the results are the same i.e. the present value is same in both the examples. This implies that there is no role of inflation in the computation of the net present value. The effect of inflation is nil in the computation of net present value because the effect of inflation is given to both, the discount rate as well as the cash flows. The numerator (cash flow) and denominator (discount rate) are increased with the same percentage; therefore, the effect of inflation gets nullified in the NPV computation. Here, it is important to note that the real cash flows never to be discounted by the nominal discount rate. If it is done, it will vitiate the results of the net present value, which may result in wrong evaluation of the investment options. Further, the essay writing services are available to provide corporate finance homework help on this issue.      

The issue of inflation in the computation of net present value is of vital importance as suggested by the experts providing financial management assignment help. For the purpose of the computation of net present value, the selection of the appropriate discount rate remains a major issue. Since the inflation affects the future cash flows, thus, it should be considered in financing decisions, but it should be remembered that in the computation of the NPV, the effect of inflation is nullified. It is the well settled economic principle that the real cash flows are to be discounted using the real discount rate and nominal cash flows are discounted using the nominal discount rate.