Abstract
This chapter discusses real interest rates, nominal interest rates, real prices, nominal prices, compounding, discounting, and the risk premium. Because all the financial statements are constructed in nominal terms, the expected inflation rate and the real increases in the prices are explicity specified. Thus, it is extremely important to understand the differences between nominal prices, constant prices, real prices, nominal interest rates, and real interest rates. Though, it is difficult to estimate the expected inflation rates, the difficulty in estimation does not mean that it is appropriate to assume that the expected inflation rates are zero. It is better to acknowledge explicitly that the expected inflation rates will not be zero and examine the extent to which the assumption about the profile of the expected inflation rate affects the outcomes of the valuation exercise. Using numerical examples to illustrate some basic ideas on cost of capital with finite cash flows is another way out to the situation, where the formulas that are derived from cash flows in perpetuity give inconsistent results when applied to finite cash flows and present an alternative approach with consistent results.
Published Version
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