Greenspan Inc. discounts cash flows at a nominal rate of 10%. Inflation over the next few years is expected to average 3%. Which of the following would be a correct adjustment for inflation when computing net present value?
A) Discount cash flows at 10%; increase revenues and expenses by 3% each year.
B) Discount cash flows at 13%; increase revenues and expenses by 3% each year.
C) Discount cash flows at 7%; ignore inflation when forecasting revenues and expenses.
D) Either A or C would be acceptable.

Question

Quizplus · Accepted Answer

The correct adjustments for inflation when computing net present value can be either to discount cash flows at the nominal rate (which includes inflation) and adjust revenues and expenses for inflation (Option A), or to discount cash flows at the real rate (nominal rate minus inflation rate) and not adjust revenues and expenses for inflation (Option C). Both methods should theoretically yield the same result.