Real and Nominal Returns

Inflation erodes the real returns on cash flows. For example, if the inflation rate is 4 percent, then a nominal cash flow of $1 has a real inflation-adjusted value of . Using our discounting rules already developed, we can generalize that a nominal gross return has an equivalent real gross return of:

where f is the inflation rate (in our example, 4 percent) and is the real net return.

Note that if the inflation rate is , then the nominal return is identical to the real return. Also, note that we can simplify this equation for the real gross return to get at the net return as follows:

The important point is that inflation affects the relevant discount rate that one uses to value a cash flow stream. We return to this topic when we look at Treasury Inflation Protected Securities, or TIPS, in the next chapter.