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Sfm-capital budgeting query

sandhya (CA FINAL) (136 Points)

18 December 2014

Hi Friends Please clear my query regarding SFM Capital budgeting.What is money rate,Inflation rate,Risk free rate,Real rate.Also explain me the difference and relation between each of them.

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3 Replies

yogesh (ARTICLE ASSISTANT) (167 Points)
Replied 19 December 2014

Risk free rate: means rate of interest earned on risk free assets. e.g. interest rate of Govt Bonds ( as govt generally never default in payment of interest & repayment of principal amount hence these bonds are called as risk free bonds & rate of interest of these bonds is called as risk free rate)

Inflation Rate: the rate at which the price of goods rises (e.g. if a product is selling today at Rs. 100 & after one year same product is seeling at Rs. 109 then inflation rate is 9% i.e 109-100/100*100)

Money rate or Nominal Rate : It means actual rate of interest earned by the investor. Suppose you deposit Rs. 100 today in Fixed deposit & after one year you received Rs. 112 then you earn Rs. 12 as interest i.e.12% This rate is know as Nominal rate of interest.

Real rate of interest: it means the rate of interest what you really ( & not actually ) earned. Suppose you have Rs. 100 now & a product also cost Rs. 100 now. So you can buy this product with this Rs. 100. But suppose instead of buying you deposit Rs. 100 in Bank FD for one year which gives interest @ 12%(Nominal Rate of Interest). So you will receive Rs. 112 at the end of the year. Now suppose at the end of year you went in the market to buy the same product,but you find that same product cost Rs. 109 now (this is due to inflation which is 9% in this case). So after buying the product you only left Rs. 3 which is your real income i.e what you really earn. & in % it is called as Real rate.( in this case real rate is 3%)

Hope this will help you. If any error in my concept then please rectify me.

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yogesh (ARTICLE ASSISTANT) (167 Points)
Replied 19 December 2014

Sum up:

Nominal Rate = Real rate + Inflation rate

Note:

Real rate of interest may be negative also. This haapens when Inflation rate is more than Nominal rate. In saving bank account you receives 6 to 7% as interest while Inflation in India is around 9 to 10%. In such case you are not earning in real sense but destroying your wealth.

The cocept of real interest is similar to concept of real profit in economics