You are trying to compare the present values of two separate streams of cash flows that have equivalent risks. One stream is expressed in nominal values and the other stream is expressed in real values. You decide to discount the nominal cash flows using a nominal annual rate of 8 percent. What rate should you use to discount the real cash flows?

Question

Quizplus · Accepted Answer

To compare the present values of two cash flows with equivalent risks, they both should be discounted at a comparable rate. The comparable rate for the real cash flows is the real rate, and thus the answer is D. Option A is incorrect as it would assume that inflation is zero, which is not realistic. Option B is incorrect as it would be used to calculate the effective annual rate for periodic compounding, but it is not relevant when comparing real and nominal cash flows. Option C is incorrect as it does not account for inflation, and the risk-free rate is typically a nominal rate. Option E is incorrect as it would only adjust for the risk premium and not the inflation component.

You Are Trying to Compare the Present Values of Two