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#8226; The IRR would be higher by a factor of 1.05
(IRRi=0=((1+IRRi=5%)/1.05)-1) (Table 4)
• If the rate of inflation were 10% the IRR would be higher
by a factor of 1.1 (IRRi=0=((1+IRRi=10%)/1.1)-1) (Table 5)
• The rate of inflation would then distort our decision
making and make us more likely to choose investments
in periods of high inflation
Inflation and Interest Rates
• Inflation rates and interest rates are related
• Other things being equal the higher the rate of inflation the
higher the rate of interest
• If we are considering an investment proposal set out in
constant prices….
• It is the real rate of interest that matters when we compare
our IRR estimate with the interest rate
• The real rate of interest (R) is given by:
1
(1 )
(1 )




i
r
R
1 4.8%
1.05
1.1
1
(1 0.05)
(1 0.10)
   


R 
where r is the nominal rate of interest
• So if r is 10% and i is 5%:
Source: Geometric means estimated from IMF International Financial Statistics 2007Interest rate used : Clearing Bank lending rateInflation rate: Derived from GDP deflator
UK Real Interest Rates (1967-2006, period averages)
Period
1967-1970
1971-1975
1976-1980
1981-1985
1986-1990
1991-1995
1996-2000
2001-2006
1967-2006
Nominal Interest Rate
6.4%
8.5%
11.8%
11.4%
11.9%
7.8%
6.2%
4.4%
8.3%
Inflation Rate
5.0%
13.1%
14.9%
6.9%
6.0%
3.5%
2.5%
2.5%
6.6%
Real Rate of Interest
1.3%
-4.1%
-2.7%
4.2%
5.5%
4.1%
3.6%
1.8%
1.6%
Interest Rates and Discount Rates
•The discount rate for any investor is determined by the opportunity cost of capital
•What is the next best alternative use of the investor’s funds?
•If the funds to be used are taken from a company’s reserves the opportunity cost might be:
–The return available from depositing the money in the bank or….
–…the return available from the next best alternative investment…..
–….assuming a capital rationing situation this is the best project that does not get into the corporate investment plan
Interest Rates and Discount Rates
•If the funds to be used will be borrowed from a bank the opportunity cost would be the interest rate on the borrowed funds
–the interest payments would otherwise be available for the company to spend on other activities
•If the funds used are borrowed from a combination of both internal sources and external borrowing the opportunity cost might be a weighted average of the two sources but…
•….most companies have some aversion to risk so the discount rate they employ is usually a bit higher than the interest rateWhat is Normal Practice?
•According to Arnold and Hatzopoulos (2000, quoted in Arnold 2005: 201):
–42% of companies in the UK use constant price cash flows and estimate a real rate of return
–39% of companies in the UK use inflated cash flows and a market rate of return
–17% take inflation into account through sensitivity analysis
–13% make no adjustment
•Since the numbers don’t add up to 100% some companies must use more than one approach!Interest Rates and Discount Rates
•In principle the discount rate used for an analysis in con