When is it better to use real cash flows rather than nominal in NPV?

Question

AcadiFi · Accepted Answer

Both methods yield the same NPV if applied consistently. The choice is practical, not theoretical.

Use nominal analysis when: (1) Contract prices are locked in nominal terms (fixed-price offtake agreements). (2) Debt service is nominal. (3) Depreciation and tax shields — always book-nominal — are material. (4) Inflation expectations differ materially across line items (labor inflation different from commodity inflation).

Use real analysis when: (1) All major cash flows scale roughly with a common inflation rate. (2) Cross-country or cross-period comparisons are needed without inflation noise. (3) Strategic analysis focuses on underlying economics rather than tax complications.

At Linden Energy's LNG project: if the offtake is 15-year Brent-indexed, capex is engineering-contracted in nominal dollars, and debt is nominal fixed-rate, you almost certainly want nominal analysis — too many items are contractually nominal to cleanly deflate.

A hybrid approach works: model revenues and opex in real terms up to year 20, then inflate to nominal to compute taxes on the correct nominal base (because depreciation is historical). Finally, discount with a nominal WACC.

For AcadiFi Level II candidates: the exam typically tests your ability to detect the mismatch. Red flags in vignettes include 'real WACC of X%' combined with depreciation tax shields, or nominal cash flows combined with 'risk-free real rate'. Always check for Fisher consistency before computing NPV.

When is it better to use real cash flows rather than nominal in NPV?

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