Real rateINFLATION AND THE REAL RATE OF INTERESTInterest rate12.00%Inflation rate5.00%

Real interest rate6.67%( 1 + Interest Rate ) / ( 1 + Inflation Rate ) - 1

EXAMPLE

Cash today100.00Plus interest12.00Cash next year112.00

Price today106.67Plus inflation5.33Price next year112.00

Infl factorINFLATION AND CONSTANT DOLLAR FACTORSCurrent price200.00Inflation rate5.00%

Year0123

Price200.00210.00220.50231.53Inflation factor100.00%105.00%110.25%115.76%Inflation Factor = Previous Inflation Factor x ( 1 + Inflation Rate )Price200.00210.00220.50231.53Constant dollar factor100.00%95.24%90.70%86.38%Price in constant dollars200.00200.00200.00200.00

Constant dollar factor = 1 / Inflation Factor

Constant dollar factor = Previous Constant Dollar Factor / ( 1 + Inflation Rate )

NPVNPV CAN BE CALCULATED IN NOMINAL OR REAL TERMS

Interest rate12.00%Inflation rate5.00%Real interest rate6.67%

Year0123

Cash flow (400,000)100,000200,000300,000PV factor100%89%80%71%PV of cash flow(400,000)89,286159,439213,534Cumulative PV(400,000)(310,714)(151,276)62,259NPV62,259

Cash flow(400,000)100,000200,000300,000Constant dollar factor100%95%91%86%Real cash flow(400,000)95,238181,406259,151 Cash Flow x Const $ FactorReal PV factor100%94%88%82%Real PV(400,000)89,286159,439213,534 Real CF x Real PV FactorCumulative real PV(400,000)(310,714)(151,276)62,259NPV62,259