In everything we’ve done to this point, we’ve talked about “the” interest rate r. But real financial markets have many different interest rates. Which one should investors use to evaluate net present values?

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Because investments’ costs and benefits occur at different times, price inflation can affect the net value of an investment, a fact we’ve ignored so far. When prices change over time, they create their own discounting effect: A future payment doesn’t have the same purchasing power as an equal-sized payment in the present. If there is inflation (rising prices), a future payment of $1,000 will buy fewer goods and services than a payment of $1,000 today. The further the payment is in the future, the more prices will likely have increased, and the larger is this purchasing power gap. Because firms and households care about real purchasing power, they need to adjust for these gaps when evaluating investments.

Economists account for inflation in these situations by drawing a distinction between nominal and real interest rates. Nominal interest rates are rates of return expressed only in currency values without regard for how much purchasing power those values hold. Real interest rates (also called inflation-adjusted interest rates) express rates of return in terms of purchasing power, the amount of goods and services that the payment can purchase. If the growth rate in the price level has reduced a future payment’s purchasing power because a dollar buys less in the future than it does in the present, real interest rates take that into account.

As long as inflation rates aren’t wildly high, the basic rule is that the real interest rate, r, is approximately the nominal interest rate, i, minus the inflation rate, π5:

r ≈ i – π

Once we have computed the real interest rate, we use it as the interest rate r in PDV and NPV calculations. This will automatically take into account the discounting effects of price changes over the lifetime of the investment as well as the other reasons future payments are discounted.

We’ve established that individuals making investment decisions should base their NPV calculation on the real interest rate. And, we know that the real interest rate is the difference between the nominal interest rate and the inflation rate. But, what is the appropriate nominal interest rate to use in this calculation?

To answer this question, it’s helpful to recall that the interest rate captures the opportunity cost of investing. It is an opportunity cost because resources used to purchase capital cannot be otherwise saved to earn interest. NPV analysis asks whether an investment’s future payoffs are worth the current costs by comparing those future payoffs to what would have been earned by simply saving the funds and earning interest. Discounting future flows in an NPV analysis puts them on comparable terms with the possible interest earned on savings.

This means that the interest rate used to compute NPVs should be the alternative rate of return that is forgone if the investment is made. If a firm is considering whether or not to build a new store, for example, it is in essence deciding between building the store or saving the funds in the financial market and earning the market rate. At the end of the chapter, we discuss how the interest rate should be modified to take into account the uncertainty inherent in risky investments.

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