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Finance · level 1

Real vs nominal rates

Inflation sits inside every nominal rate. Strip it out exactly with the Fisher relation; the subtraction shortcut overstates the real rate by roughly i × π.

Theory: Corporate Finance 

Worked example: Nominal discount rate 12%, expected inflation 3%. What real rate should discount real cash flows?

nominal12%
inflation3%
real8.74%

Step by step

  1. 1

    Fisher

    (1.12 / 1.03) − 1 = 8.74%

  2. 2

    Approximation

    12% − 3% = 9% (slightly too high)

  3. 3

    Rule

    Nominal cash flows at the nominal rate, real cash flows at the real rate. Mixing them is the most common capital-budgeting error.

Nominal discount rate 12%, expected inflation 3%. What real rate should discount real cash flows? = 8.74

The theory behind it

Intuition

Finance is time and risk applied to cash: move every cash flow to the same date at a rate that reflects its risk, then compare.

Common pitfalls

  • ×Discounting a nominal flow at a real rate (or vice versa).
  • ×Mixing enterprise-value and equity-value numbers in the same ratio.

In the interview

Valuation, WACC, LBO and accretion rounds — where a wrong bridge is a wrong answer.