Definition of Nominal Rate of Return
The nominal rate of return (also known as the inflationary rate of return) is the rate of return required over the period of time after considering the present inflation rate prevalent in the economy, computed either using an addictive model or multiplicative model, and such return is mostly used in confirming the viability of the proposed project or for discounting purpose.
Explanation
- Suppose you invest a sum amount in the bank & the rate of return is say 7%. Such interest rate offered by banks does not cover the effect of inflation. If inflation is lower, the investors ignore the difference. However, if the inflation is higher, the investors take the difference on a serious note & avoid investing in safe deposits.
- That’s the difference a real interest & inflation rate has. So the difference between the two is inflation.
- An increase or decrease in inflation has an effect on prices. The prices increase as a result of inflation. An increase in inflation is many times treated as an increase in GDP growth percentage. Such increase is short-term & the economy returns back to equilibrium if the growth in GDP is not sustainable.
- Thus, inflation is used in various finance disciples, and the list is never-ending.
Formula for Nominal Rate of Return
There are two methods for the computation of the nominal rate of return.
Method I: Addictive Method
Nominal Rate of Return = Real Interest Rate + Inflation Premium
Method II: Multiplicative Method
Nominal Rate of Return = Real Interest Rate * (1+inflation Premium)
Explanation: The multiplicative model is widely in the finance world. Obviously, the result from the multiplicative model results in a higher inflation rate as compared to the addictive model. Then why do we use the multiplicative model? The reason is the compounding effect of the inflation rate. The inflation today was a multiplicative of inflation yesterday.
Example of Nominal Rate of Return (With Excel Template)
Let’s take an example to better understand the Nominal Rate of Return calculation in a better manner.
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Example #1
Suppose a person has invested $ 450000 today in a fund. The return received after 1 year is $ 485600. We need to compute the nominal rate of return earned by the said person
Solution:
Particulars | Amount ($) | |
A | Amount of Investment | 450000 |
B | Realisation after one year | 485600 |
C | Difference (B-A) | 35600 |
D | Percentage Return (C/A)*100 | 7.91% |
Explanation: What we observe here is the rate of return earned. Can this be termed as a nominal rate of return? Absolutely yes. Here, 7.91% reflects the impact of the real interest rate plus the inflation prevalent in the economy.
Example #2
Let us take a classic example used world-wide:
Suppose a bond of the face value of $ 100,000 pays a coupon of 8% over the period of 5 years & redeemable at a 10% premium. The expected rate of return is 10%. The cash flows will be received in two installments during the year, i.e., half-yearly. The investor wants to know the “should be a price” of the bond today.
Solution:
Amount of coupon per period | $4,000 |
Number of periods | 10 |
Discount rate to be used | 5.00% |
Discounting factor is calculated as
Discounted Cashflows is calculated as
Periods | Cashflows | Discounting factor | Discounted Cashflows |
1 | $ 4,000 | 0.9524 | 3,810 |
2 | $ 4,000 | 0.9070 | 3,628 |
3 | $ 4,000 | 0.8638 | 3,455 |
4 | $ 4,000 | 0.8227 | 3,291 |
5 | $ 4,000 | 0.7835 | 3,134 |
6 | $ 4,000 | 0.7462 | 2,985 |
7 | $ 4,000 | 0.7107 | 2,843 |
8 | $ 4,000 | 0.6768 | 2,707 |
9 | $ 4,000 | 0.6446 | 2,578 |
10 | $ 4,000 | 0.6139 | 2,456 |
10 | $ 1,10,000 | 0.6139 | 67,530 |
Total | 98,417 |
Thus, the bond should be bought not higher than $ 98417 if he requires the return of 10% compounded semi-annually.
Explanation
- The required rate of return here is 10%. This rate includes inflation as well as the real interest rate.
- The bond will pay a flat coupon of $ 4000 per period. However, if the investor needs to have a higher rate of return. He needs to purchase the same bond at less than face value.
- The “should be” price computed above is compared with the actual price of the bond. If the actual price is higher, it is suggested that the investor should sell the bond now. If the actual price is lower than even the fair value as computed, it is suggested to buy the stock. In the worst case, if the actual price of a bond is very near to the price computed above, it is suggested to hold the bond or do nothing.
- As you can see, the slightest change in the required rate of return can change the decision for bonds.
Importance of Nominal Rate of Return
- The nominal interest is very important in the finance & economic world.
- It is necessary for computing various discounted values.
- The increase in nominal rate progressively defines the increasing rate of inflation in the economy.
- The whole economic base is related to the nominal rate of return. Therefore, many financial decisions are impacted as a result of a slight change in the nominal rate of return.
- Reduction in nominal rate results in higher output values & vice-e-versa.
Advantages
Some of the advantages are given below:
- It is used in discounting the cashflows standing at different intervals over the projected tenure of the project.
- Further such rate of return is used to compute the net present values of cash flows. If the net cash flows are able to survive the effect of the nominal interest rate, the project is said to be viable.
- Such interest rate is compared with the internal rate of return. The nominal rate of return is considered to cost of the project & such requirement is the minimum quantum of return. If the internal rate of return is lower than the nominal rate of return, the project is said to have reduced the wealth of shareholders & is, therefore, not viable to carry out.
Disadvantages
Some of the disadvantages are given below:
- It includes inflation & thus, the results are always inflation than the actual scenario.
- Firms need to think upon the appropriate nominal rate. Any wrong basis in the rate may provide devastating results.
- The nominal rate of return has now become the only basis of decision-making in finance, ignoring the other disciples of finance.
- An important project may be rejected only due to negative NPV. Thus, other factors should be considered to confirm whether the project is actually not feasible.
Conclusion
The nominal rate of return is the backbone of the finance world today. Any computation in finance without an appropriate discount rate is considered vague & irrational. Thus, the nominal rate of return has gained much importance in the changing world of the economic environment.
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