Core Capital Discount Rate

CFA Level III Portfolio Management
#1

Hi All,

Should the core capital discount rate should we be using the state risk free rate or “real risk free rate”

Real Risk Free Rate = ( 1+ Nominal Rate / 1 + Inflation ) -1

I have seem some practice problem (Kaplan) using both version. Any rule of thumb out there?

Thanks.

#2

Nominal to nominal. Real to real. If you use real RFR in denominator, you must not to compound for inflation in numerator and vice versa, if nominal discount rate is used, you have to multiply for an inflation rate in numerator.

#3

Flash,

I am not sure that is entirely correct.

There are a few curve balls to consider:

1 - Spending rate increases can be more or less than inflation. I believe you just have to solve for the spending based on the information for the designated period.

  1. Looking at the foot note on Vol 2 page 284 (foot note 16) you can see the text says the more accurate computation will be Real Risk Free Rate = (1+Nominal / 1+Inflation) -1
#4

“The capitalized value of their core capital spending needs equals the product of the joint probability of survival and the real spending need for each year discounted using the real risk-free rate. Alternatively, one may discount the nominal expected cash flow at the nominal risk-free rate. Using the first approach, the real cash flows will remain constant and be discounted at 2 percent (or 5 percent less 3 percent).”

CFAI Curriculum