Understanding Real Rate of
Return and Cash Flow
Key Points:
● Impact of Inflation: The lecture emphasizes the importance of considering inflation
when evaluating investment returns and cash flows.
● Cost of Capital: Cost of capital can represent various things, including market rate of
return.
● Nominal vs. Real: Distinguishes between nominal (money) and real rates of return and
cash flows, highlighting how nominal values can be misleading due to inflation.
● I-Bonds Example: Discusses I-Bonds in Hong Kong as an example of inflation-linked
bonds with a real rate of return close to zero.
● Currency Exchange Risk: Briefly mentions currency exchange risk as another factor to
consider in international investments.
● Formulas for Calculation: Provides formulas for calculating real rate of return and real
cash flow, taking inflation into account.
● Practical Application: Demonstrates how to apply these concepts in a project
investment scenario to determine the true NPV.
Important Concepts:
● Real Rate of Return:
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● The actual return on an investment after accounting for inflation. It reflects the true
increase in purchasing power.
● Real Cash Flow:
○ The actual cash flow adjusted for inflation, representing the true value of the cash
received in terms of current purchasing power.
● Nominal Rate of Return (Money Rate of Return):
○ The stated return on an investment without considering the effects of inflation. It
can be misleading in high-inflation environments.
● Inflation Rate:
○ The rate at which the general level of prices for goods and services is rising, and
subsequently, purchasing power is falling.
● Cost of Capital:
○ The rate of return that a company must earn to justify the cost of capital.
Relevant Terminology:
● 通脹 (Tōngzhàng): Inflation (Mandarin Chinese)
● 股市 (Gǔshì): Stock Market (Mandarin Chinese)
● Written Down Allowance: A tax allowance for the depreciation of assets.
● Cap M: Capital Asset Pricing Model
● NPV: Net Present Value
Examples or Applications:
● Student Portfolio: A student closing their portfolio early due to political threats and stock
market volatility.
● 恒生指数 (Héngshēng Zhǐshù): Hang Seng Index, used to illustrate real rate of return
calculation.
● I-Bonds: Inflation-linked bonds in Hong Kong, providing a real rate of return close to
zero.
● Project Investment: A company considering a project with a given investment, cash
flows, cost of capital, and inflation rate.
Supporting Data:
● European Union inflation target: 4.25% to 4.5%
● UK one-year bond value: 3.8%
● UK inflation: 4%
Questions and Answers:
● Q: What does IR represent in the formula?
○ A: Inflation Rate
● Q: What does RR represent?
○ A: Real Rate of Return
● Q: What does MR represent?
○ A: Money Rate of Return or Nominal Rate of Return
Follow-up Actions:
● Discuss currency exchange risk in the next session.
● Portfolio 2 review