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Financial Management · Allowing for inflation and taxation in DCF

Real vs Nominal Cash Flows and Discount Rates in ACCA FM

Updated 11 October 2026 · Fact-checked

Nominal (money) cash flows include inflation; real cash flows are in today's prices. Discount nominal cash flows at the nominal (money) rate and real cash flows at the real rate. The Fisher formula links them: (1 + money rate) = (1 + real rate) × (1 + inflation rate). Never mix the two.

Understand Real vs Nominal Cash Flows and Discount Rates

A nominal (money) cash flow is the actual cash you expect to receive or pay in the future. It includes the effect of inflation. A real cash flow is the same amount expressed in today's purchasing power, with inflation stripped out.

Investors also think in two ways. The money (nominal) discount rate is the return they need in actual cash terms. It already includes compensation for inflation. The real discount rate is the return they need after inflation is removed.

The golden rule is consistency. Money cash flows are discounted at the money rate. Real cash flows are discounted at the real rate. If you do this correctly, both routes give the same NPV, provided the same general inflation rate is used throughout. Mixing them gives a wrong answer.

The Fisher formula links the rates: (1 + i) = (1 + r) × (1 + h). Here i is the money rate, r is the real rate and h is the inflation rate. Notice it is multiplicative. You do not simply add inflation to the real rate, although that is a rough estimate.

In exams, the company's WACC or required return is usually a money rate because it comes from market data such as share prices and bond yields. So the usual task is to inflate cash flows and discount at the money rate. If cash flows are given in current prices and the rate is real, you can discount directly. Read the wording carefully.

Key rules to remember

Fisher formula
(1 + i) = (1 + r) × (1 + h)
i = money (nominal) rate, r = real rate, h = general inflation rate. Use decimals.
Money rate from real rate
i = (1 + r) × (1 + h) − 1
Use this when you have a real rate and inflation and need the rate for money cash flows.
Real rate from money rate
r = (1 + i) ÷ (1 + h) − 1
Use this when you have a money rate such as WACC and need to discount real cash flows.
Inflating a cash flow
Money cash flow in year n = current price cash flow × (1 + inflation)^n
Use the inflation rate that applies to that specific cash flow. Year 1 is inflated by one year.
Consistency rule
Money cash flows ÷ money rate; real cash flows ÷ real rate
Never discount money flows at a real rate or real flows at a money rate.

How to solve Real vs Nominal Cash Flows and Discount Rates questions

Use this method for any question that gives cash flows, inflation and a discount rate.

  1. 1Read the question to see whether each cash flow is stated in current (real) prices or in future (money) terms.
  2. 2Identify whether the given discount rate is a money rate or a real rate. WACC or a market return is normally a money rate.
  3. 3Decide your route: either inflate the cash flows and use the money rate, or keep the flows real and use the real rate.
  4. 4If you need to convert a rate, apply the Fisher formula using decimals and the general inflation rate.
  5. 5If you inflate, use (1 + h)^n for each year n, using the correct inflation rate for each cash flow if rates differ.
  6. 6Discount each year's cash flow using the correct discount factor for that year, then sum to get the NPV.
  7. 7State the decision: accept if NPV is positive, and say which basis you used.

Quickest way: Inflate then discount at the money rate

When to use it: Use when the given rate is a money rate such as WACC and cash flows are in current prices, which is the most common exam setup.

  1. Underline the rate type. If it is a money rate, do not convert it.
  2. Multiply each current-price cash flow by (1 + h)^n.
  3. Discount at the given money rate.
  4. If the question gives a real rate and all flows are real, skip inflation and discount directly.
  5. Only use the Fisher formula when the rate and the cash flows are on different bases.

Common mistakes in Real vs Nominal Cash Flows and Discount Rates

  • Discounting money cash flows at a real rate (or real flows at a money rate).

    Students miss the wording of the question or forget the consistency rule.

    Fix: Label every cash flow and every rate as real or money before calculating. Match them.

  • Adding inflation to the real rate instead of using the Fisher formula.

    It is a quick shortcut and gives a close answer.

    Fix: Multiply the (1 + r) and (1 + h) terms, then subtract 1. For example, 5% real and 3% inflation gives 8.15%, not 8%.

  • Inflating Year 1 cash flows by zero years or Year 0 flows by one year.

    Confusion about the timing of base-price flows.

    Fix: A Year n flow in current prices is multiplied by (1 + h)^n. Year 0 flows are not inflated.

  • Using the money rate to deflate or inflate by mistake, such as inflating cash flows with the discount rate.

    Students mix up the inflation rate and the discount rate.

    Fix: Inflation rate only changes cash flows. The discount rate only discounts them.

  • Using percentage figures in the Fisher formula instead of decimals.

    Rushing under time pressure.

    Fix: Write 8% as 0.08 and 1.08 inside the brackets before multiplying.

Worked examples

Example 1

A company's real required return is 6% and general inflation is 4%. Calculate the money (nominal) discount rate. Then calculate the real rate if the money rate is 12% and inflation is 5%.

Show the solution
  1. Part 1: use (1 + i) = (1 + r) × (1 + h).
  2. (1 + i) = 1.06 × 1.04 = 1.1024.
  3. i = 1.1024 − 1 = 0.1024, or 10.24%.
  4. Part 2: use (1 + r) = (1 + i) ÷ (1 + h).
  5. (1 + r) = 1.12 ÷ 1.05 = 1.066667.
  6. r = 0.066667, or 6.67% (to two decimal places).

Answer: Money rate = 10.24%. Real rate = 6.67%.

Example 2

A project needs an investment of ₹10,00,000 now (Year 0). It will produce net cash flows of ₹6,00,000 in Year 1 and ₹7,00,000 in Year 2, both stated in current prices. General inflation is 5% a year. The company's money cost of capital is 10.25%. Calculate the NPV using money cash flows, then confirm using real cash flows and the real rate.

Show the solution
  1. Money route: inflate the flows.
  2. Year 1 money flow = 6,00,000 × 1.05 = ₹6,30,000.
  3. Year 2 money flow = 7,00,000 × 1.05² = 7,00,000 × 1.1025 = ₹7,71,750.
  4. Discount at 10.25%: Year 1 factor = 1 ÷ 1.1025 = 0.9070; Year 2 factor = 1 ÷ 1.1025² = 1 ÷ 1.21551 = 0.8227.
  5. PV Year 1 = 6,30,000 ÷ 1.1025 = ₹5,71,429 (rounded).
  6. PV Year 2 = 7,71,750 ÷ 1.215506 = ₹6,34,921 (rounded).
  7. NPV = 5,71,429 + 6,34,921 − 10,00,000 = ₹2,06,350.
  8. Real route: real rate = 1.1025 ÷ 1.05 − 1 = 1.05 − 1 = 5%.
  9. PV Year 1 = 6,00,000 ÷ 1.05 = ₹5,71,429. PV Year 2 = 7,00,000 ÷ 1.1025 = ₹6,34,921.
  10. NPV = 5,71,429 + 6,34,921 − 10,00,000 = ₹2,06,350. Both routes agree.

Answer: NPV = ₹2,06,350 (positive, so accept the project). Both methods give the same result.

Exam tips

  • Look for the words 'current prices', 'real terms', 'in today's money' or 'money terms'. They tell you the basis of the cash flows.
  • In Section B and Section A objective questions, the Fisher calculation is often the whole question. Use a calculator, keep decimals and watch the rounding of the options.
  • Because objective questions are all or nothing, check whether the question asks for the money rate, the real rate or the NPV before you start.
  • In Section C, show the inflation step clearly in your workings, so you earn method marks even if a number slips.
  • If different cash flows have different specific inflation rates, inflate each at its own rate, but discount all at the money rate.

Practice questions from Allowing for inflation and taxation in DCF

Real vs Nominal Cash Flows and Discount Rates in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Real vs Nominal Cash Flows and Discount Rates: frequently asked questions

What is the difference between real and nominal cash flows?

Nominal (money) cash flows include the effect of inflation and show the actual cash received or paid. Real cash flows are stated in today's prices with inflation removed. They must be discounted at matching rates.

How do I calculate the nominal discount rate from the real rate and inflation?

Use the Fisher formula: nominal rate = (1 + real rate) × (1 + inflation) − 1. For example, 5% real and 3% inflation gives 1.05 × 1.03 − 1 = 8.15%. Use decimals and subtract 1 at the end.

Should I use the real or money discount rate in NPV?

Use the one that matches your cash flows. Money cash flows go with the money rate and real cash flows with the real rate. In exams, the cost of capital is usually a money rate, so you normally inflate the cash flows.

Do I always get the same NPV from the real and money methods?

Yes, if all cash flows are inflated at the same general inflation rate and the rates are linked by the Fisher formula. If different cash flows have different inflation rates, the money method is the safer route.