| Abstract: | ![]()
The aim of this paper is to clarify the confused issue of the effect of inflation on the discounting procedure for investment appraisal. The standard approach is considered, together with the impact of inflation, and the problem of how to adjust the standard approach to take account of inflation. The point is made that it is usually easiest to estimate expected returns in current prices, in which case the discount rate should reflect the real opportunity cost of capital, to avoid mixing real returns and nominal interest in a manner which leads to the rejection of worthwhile projects. An example is given of how the real rate of interest can be computed from the nominal rate of interest and the rate of inflation, and the difference this makes to discounting a sample project. The paper then illustrates how real rates of interest have frequently been negative over the past decade and how this implies that projects may be acceptable even if the sum of future undiscounted returns is less than the initial outlay. The conclusion drawn is that investors should maximize economic profit defined as the surplus over opportunity cost, which reduces the deterrent of nominally high interest rates, for the maximization of surplus over opportunity cost has the corollary of minimization of opportunity loss. |
