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Intro to Finance
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Intro to Finance
University Study Guides
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Inflation and Real Return
Inflation
- General increase in prices of goods and services. Consequently fall in purchasing power.
- Inflation is undesirable to investors receiving fixed cash flows. o Ex: retirees and pension payments.
Real vs Nominal Returns
- Real cash flows are adjusted for inflation and expressed in terms of purchasing power. o Real cash flows should be discounted by a real discount rate.
- Nominal cash flows are not adjusted for inflation. o Nominal cash flows should be discounted by a nominal discount rate.
- Fisher Rule:
Wize Concept
When discounting, always discount nominal cash flows using nominal interest rate and discount real cash flows with real interest rate.
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Example: Inflation
Steve plans on retiring in 20 years. The average retiree in his neighbourhood currently lives comfortably with $100,000 per year and Steve is planning to live a similar life when he is done working. Inflation is expected to be 2% for the foreseeable future and Steve's investments earn an average of 8% per year. How much should Steve invest today into his investment account if he wishes to retire with enough to live comfortably for the rest of his life?
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Example: Inflation and Real Returns
Compute the real return earned on a bond a zero-coupon bond that was purchased last year for $820 and sold today for $930. It is known that inflation this year was 2%.
Practice: Inflation
A restaurant owner in Vancouver was approached by a team of marketing students from UBC that claim they can help bring customers to the restaurant. Their services will cost the restaurant an upfront cost of $4,000 for preparing a website and social media profiles as well as an on-going management fee of $1,000 per year for 7 years with the first payment due today. The management fee is expected to increase at the rate of inflation, expected at 3% for the foreseeable future. The restaurant's cost of capital is 8%, what is the cost of the marketing services in present value terms?
Round your final answer to 2 decimal places.