Explain the use of real and nominal discount rates in discounting cash flows. Which is used more often and why?
Hussey & Hussey (1999) have pointed out the important thing to remember is, real cash flows must only be discounted by the real interest rates while the nominal cash flows must only be discounted by the nominal interest rates. Because, the real cash flows does not include the affect of inflation and discounting by the nominal interest rate will both automatically but artificially lower down the Net Present Value and the financial analyst may reject the project.
Similar is the case with nominal cash flows, as they have not included the affect of inflation an if are discounted by nominal interest rate which may also add up the affect of inflation, then it will cause an artificial but higher Net Present Value and again the analyst may reject the project based on these wrong way of calculations.
Another important fact is the use of nominal interest rate by all analyses and financial projectors based on the assumption that all cash flows are nominal.