4.5 Real versus nominal cash flows

Real cash flows and nominal cash flows are terms used to differentiate between cash flows that are adjusted for inflation (real) and those that are not (nominal).

1. Nominal Cash Flows: Nominal cash flows are expressed in current dollars and are not adjusted for inflation. They represent the actual cash inflows or outflows that occur in a given period without considering changes in purchasing power. Nominal cash flows do not account for the impact of inflation on the value of money over time.
2. Real Cash Flows: Real cash flows are adjusted for inflation, reflecting changes in purchasing power over time. They are expressed in constant dollars, which means that they account for the effects of inflation and provide a more accurate measure of the true economic value of cash flows. Real cash flows remove the inflationary component, allowing for a more meaningful analysis of the purchasing power and actual changes in wealth.

The distinction between real and nominal cash flows is important in financial analysis and decision-making, particularly when assessing the profitability and economic feasibility of investments or evaluating the performance of projects over time. By adjusting cash flows for inflation, real cash flows enable a more accurate comparison and assessment of the true profitability and value generated by an investment or project.

For example, consider an investment that generates a nominal cash flow of $10,000 per year over a period of five years. However, inflation is averaging 3% per year during that period. To determine the real cash flows, we would need to adjust the nominal cash flows by the inflation rate. If we assume a constant inflation rate of 3%, the real cash flows would be lower each year to reflect the loss in purchasing power caused by inflation.

Understanding the distinction between real and nominal cash flows is crucial for financial analysis, investment evaluation, and decision-making. It allows for a more accurate assessment of the impact of inflation on cash flows and provides a better understanding of the true economic value and performance of investments or projects over time.