Nominal interest rate is the interest rate that includes inflation into the real interest rate. If the nominal interest rate offered by a project is 5% in a country where the annual inflation rate is 3%, the approximate real interest rate will be 2%.
In investment appraisal projects where cash flows are either denominated in real terms and interest rate is given in nominal terms, and vice-versa. To perform the investment appraisal accurately we need to match the cash flows and interest rates either in nominal terms or real terms. To reach the nominal interest rate out of real rate and inflation rate the following equation can be used.
1+ Nominal interest rate = (1+Real interest rate) x (1+ Inflation rate)
Nominal interest rate = [(1.02) x (1.03) ] – 1 = 5.06%
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