Reading: Treating Inflation Consistently

When valuing projects, we have to make sure that we treat inflation consistently. This section briefly introduces the topic of inflation and explains how to make sure that we correctly incorporate inflation into our valuation. The resulting procedure is fairly simple:

• We can value projects in nominal terms or in real terms. "Real" means that we deflate the nominal cash flows and discount rate with the expected rate of inflation.
    
• We can discount nominal cash flows at the nominal discount rate.
   
• Alternatively, we can discount real cash flows at the real discount rate.
   
• When properly applied, both approaches yield the same result!

The section proceeds as follows:

• We start with a brief discussion of inflation and how it affects purchasing power and expected returns.
   
• Then we show how to treat inflation consistently in project valuation.