Description
A major impact on financial theory and the practice of financial decision making has been the economic instability, especially in prices, evidenced in the U.S. economy since the mid 1960’s.
Impact of Inflation on Capital Budgeting
Decisions : An Empirical Study
ABSTRACT
A major impact on financial theory and the practice of financial decision making has been the economic
instability, especially in prices, evidenced in the U.S. economy since the mid 1960's. Inflation in the past few years
has not been a major macroeconomic problem, but its spectre, as demonstrated by the Fed's recent increases in interest
rates, is never for the agendas of financial decision makers. Macro economic instability has necessitated that
expectations about the future rate of inflation be taken into consideration in making decisions about which capital
projects will be undertaken by a firm. Nominal cash flows determine its degree of profitability. However, in making
the capital budgeting decision both real and nominal concepts must be considered. The purpose of this paper is to
continue the discussion of the role of inflation in capital budgeting, and to focus on the individual components of the
process to draw specific conclusions with respect to the
interaction between the cost of capital, inflation, and the cash flow variables within a DCF -IRR framework.
Keywords : Financial Decision Making, Inflation, Macro Economic I nstability, Capital Budgeting Decisions.
1. INTRODUCTION
In today's complex business environment, making capital budgeting decisions are among the most important
and multifaceted of all management decisions as it represents major commitments of company's resources and have
serious consequences on the profitability and financial stability of a company. It is important to evaluate the proposals
rationally with respect to both the economic feasibility of individual projects and the relative net benefits of alternative
and mutually exclusive projects. It has inspired many research scholars and is primarily concerned with sizable
investments in long-term assets, with long-term life.
The growing internationalisation of business brings stiff competition which requires a proper evaluation and
____________________________
1
Research
2
Assistant
Scholar, MBA Department, Manav Bharti University, Solan, Himanchal Pradesh, INDIA.
Professor, MBA Department, Delhi Institute of Advanced Studies, Rohini, New Delhi, INDIA.
*Correspondence : [email protected]
Monika Gulia / VSRD International Journal of Business & Management Research Vol. 2 (4), 2012
weightage on capital budgeting appraisal issues viz. differing project life cycle, impact of inflation, analysis and
allowance for risk. Therefore financial managers must consider these issues carefully when making capital budgeting
decisions. Inflation is one of the important parameters that govern the financial issues on capital budgeting decisions.
Managers evaluate the estimated future returns of competing investment alternatives. Some of the alternatives
considered may involve more risk than others. For example, one alternative may fairly assure future cash flows,
whereas another may have a chance of yielding higher cash flows but may also result in lower returns. It is because,
apart from other things, inflation plays a vital role on capital budgeting decisions and is a common fact of life all over
the world. Inflation is a common problem faced by every finance manager which complicates the practical investment
decision making than others. Most of the managers are concerned about the effects of inflation on the project's
profitability. Though a double digit rate of inflation is a common feature in developing countries like India, the manager
should consider this factor carefully while taking such decisions.
In practice, the managers do recognize that inflation exists but rarely incorporate inflation in the analysis of
capital budgeting, because it is assumed that with inflation, both net revenues and the project cost will rise
proportionately, therefore it will not have much impact. However, this is not true; inflation influences two aspects viz.
Cash Flow and Discount Rate.
A major impact on both financial theory and the practice of financial decision making has been the economic
instability, especially in prices, evidenced in the U.S. economy since the mid 1960's. Inflation in the past few years has
not been a major macroeconomic problem, but its spectre, as demonstrated by the Fed's recent increases in interest
rates, is never for the agendas of financial decision makers. Macro economic instability has necessitated that
expectations about the future rate of inflation be taken into consideration in making decision(s) about which capital
projects will be undertaken by a firm. Nominal cash flows determine its degree of profitability. However, in making
the capital budgeting decision both real and nominal concepts must be considered. The purpose of this paper is to
continue the discussion of the role of inflation in capital budgeting, and to focus on the individual components of the
process to draw specific conclusions with respect to the
interaction between the cost of capital, inflation, and the cash flow variables within a DCF -IRR framework.
2. CAPITAL BUDGETING AND INFLATION
Capital budgeting or investment appraisal is a process which anticipates expenses pertaining to assets as well as
cash flows in the future. Investment appraisal takes into account the various factors which impact expenditure in the
long run. Inflation is one such factor, which impacts investments and returns.
Inflation and capital budgeting are closely related and at no cost capital budgeting can be completed without
taking into account inflation. It is a known fact that inflation causes our purchasing power to decline. So, if we buy an
asset for $ 5,000 today, it is probable that the same asset can be bought for $ 10,000 after a couple of years. However,
it is assumed that the project cost as well as net revenues increase in a proportionate manner with inflation. For this
reason, in reality rates of inflation are not taken into account. But this is not true always, inflation does affect capital
budgeting. Inflation and capital budgeting are bound to affect cash flows.
Page 160 of 166
Monika Gulia / VSRD International Journal of Business & Management Research Vol. 2 (4), 2012
3. EFFECTS OF INFLATION ON CAPITAL BUDGETING
Inflation affects discount rates and cash flows. There are two factors on which inflation acts. They are discount
rate and cash flow.
3.1. Cash Flows
Let us assume that r refers to the revenues; t refers to the tax rate; c is the cost and d is the depreciation. By
arranging the above variables in a formula, the following is obtained.
r c t d r
c t dt
Inflation affects (r-c) (1-t), which is on the right side of the equation. But Inflation does not impact dt. The
reason can be attributed to the fact that historical costs determine depreciation costs. This implies that inflation has a
tendency to decrease the value of real rate of return. Studies reveal that Net cash flow is more as compared to real cash
flows provided we do not take inflation into account.
3.2. Discount Rates
Discount rates refer to the rate of return, which is the required rate or the target rate. The project cost is inflation
adjusted. This adjustment is usually done in the premiums. The required rate or the target rate of return for the
investors ought to be the same as real inflation return together with the expected inflation rate.
3.2.1. Case 1: Does inflation impact capital budgeting analysis?
The answer is a qualified yes, i.e., inflation does have an impact on the numbers that are used in capital
budgeting analysis. But it does not have impact on the results of the analysis if certain conditions are satisfied. To
show what we mean by this statement, we will use the following data.
For instance, Martin Company wants to purchase a new machine that costs $36,000. The machine would
provide annual cost savings of $20,000, and it would have a three-year life with no salvage value. For each of the next
three years, the company expects a 10% inflation rate in the cash flows associated with the new
machine. If the company's cost of capital is 23.2%, should the new machine be purchased?
To answer this question, it is important to know how the cost of capital was derived. Ordinarily, it is based on
the market rates of return on the company's various sources of financing - both debt and equity. This market rate of
return includes expected inflation; the higher the expected rate of inflation, the higher the market rate of return on debt
and equity. When the inflationary effect is removed from the market rate of return, the result is called a real rate of
return. For example, if the inflation rate of 10% is removed from the Martin's cost of
capital of 23.2% the real cost of capital is only 12% as shown below:
Case 1: Martin Company
Reconciliation of the Market-Based and Real Costs of Capital
The real cost of capital 1 2 .0 %
The inflation factor 1 0 .0
The combined effect (12% 10% = 1.2%) 1 .2
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Monika Gulia / VSRD International Journal of Business & Management Research Vol. 2 (4), 2012
The market based cost of capital 2 3 .2 %
Solution A: Inflation Not Considered:
Present
Amount of Value of
Item Year(s) Cash Flows 12% Factor Cash Flows
Initial investment Now $(36,000) 1 .0 0 0 $(36,000)
Annual cost savings 1-3 20,000 2 .4 0 2 48,040
Net present value $12040*
Solution B: Inflation Considered:
Price Present
Amount of Price Index Adjusted 2 3 .2 % Value of
Item Year(s) Cash Flows Number** Cash Flows Factor*** Cash Flows
Initial
investment
Annual cost
savings
Net present
value
Now
1
2
3
$(36,000)
20,000
20,000
20,000
1 .0 0 0
1 .1 0 0
1 .2 1 0
1 .3 3 1
$(36,000)
22,000
24,200
26,620
1 .0 0 0
0 .8 1 2
0 .6 5 9
0 .5 3 5
$(36,000)
17,864
15,948
14,242
$12,054*
*These amounts are different only because of rounding errors
**Computation of the price inde3x numbers, assuming a 10% inflation rate each year: Year 1, (1.10) = 1.10; Year
2, (1.10)
2
= 1.21; Year 3, (1.10) = 1.331
***Discount formulas are computed using the formula 1/(1 + r)
n
, where r is the discount factor and n is the
number of years. The computations are 1/1.232 = 0.812 for year 1; 1/(1.232)
2
= 0.659 for year 2; and 1/(1.232)
3
=
0.535 for year 3.
One cannot simply subtract the inflation rate from the market cost of capital to obtain the real cost of capital.
The computations are bit more complex than that.
When performing a net present value analysis, one must be consistent. The market based cost of capital reflects
inflation. Therefore, if a market based cost of capital is used to discount cash flows, then the cash flows should be
adjusted upwards to reflect the effects of inflation in forthcoming periods. Computations of Martin Company under this
approach are given in solution B Above.
On the other hand, there is no need to adjust the cash flows upward if the "real cost of capital" is used in the
analysis (Since the inflationary effects have been taken out of the discount rate). Computation for the Martin Company
under this approach is given in solution A above. Note that under solution A and B the answer will be same (within
rounding error) regardless of which approach is used, so long as one is consistent and all of the cash flows associated
with the project are affected in the same way by inflation.
Several points need to be noted about solution B, where the effects of inflation are explicitly taken into account.
First, not that the annual cost savings are adjusted for the effects of inflation by multiplying each year's cash savings
by a price index number that reflects a 10% inflation rate (Observe from the foot notes to the solution how the index
number is computed for each year). Second, note that the net present value obtained in solution B, where inflation is
explicitly taken into account, is the same, within rounding error, to that obtained in solution A, where the inflation
effects are ignored. This result may seem surprising, but it is logical. The reason is that we have adjusted both the cash
flows and the discount rate so that they are consistent, and these adjustments cancel each other out across the two
solutions.
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Monika Gulia / VSRD International Journal of Business & Management Research Vol. 2 (4), 2012
3.2.2. Case 2: How Does Inflation Impact Capital Budgeting?
The accuracy of capital budgeting decisions depends on the accuracy of the data regarding cash inflows and
outflows. For example, failure to incorporate price-level changes due to inflation in capital budgeting situations can
result in errors in the predicting of cash flows and thus, in incorrect decisions.
What are the ways in which to incorporate price-level changes into capital budgeting decision?
Typically, an analyst has two options when dealing with a capital budgeting situation with inflation: (1) either
restate the cash flows in nominal terms and discount them at a nominal cost of capital (minimum required rate of
return), or (2) restate both the cash flows and cost of capital in constant terms and discount the constant cash flows at a
constant cost of capital. The two methods are basically equivalent.
For instance, a company has the following projected cash flows estimated in real terms:
Real Cash Flows (000s)
Period 0 1 2 3
-100 35 50 30
The nominal cost of capital is 15%. Assume that inflation is projected at 10% a year. Then the first cash flow for
year 1, which is $35,000 in current dollars, will be 35,000 x 1.10 = $38,500 in year 1 dollars. Similarly, the cash flow
for year 2 will be 50,000 x (1.10)
2
=$60,500 in year 2 dollars, and so on. If one discounts these nominal cash flows at
the 15% nominal cost of capital, one has the following net present value (NPV) in thousands of
dollars:
Period
0
1
2
3
Cash Flows
-100
3 8 .5 6
0 .5
3 9 .9
T3
1
0 .8 7 0
0 .7 5 6
0 .6 5 8
Present Values
-100
3 3 .5 0 4 5 .7
4
2 6 .2 5
NPV = 5.49 or $5,490
Instead of converting the cash-flow forecasts into nominal terms, one could convert the cost of capital into real
terms by using the following formula: Real cost of capital =1 + nominal cost of capital)/(1 + inflation rate)- 1
In the example, this gives:
Real cost of capital = (1 + .15)/(1 + .10) - 1
= 1.15/1.10 - 1
= 1.045 - 1
= .0 4 5 o r 4 .5 %
One will obtain the same answer except for rounding errors ($5,490 vs. $5,580).
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Monika Gulia / VSRD International Journal of Business & Management Research Vol. 2 (4), 2012
Period
0
1
2
3
Cash Flows
-100
35
50
30
T3 = 1/(1 + .045)n
1
1/(1+.045)=.957
1/(1.045)2=.916
1/(1.045)3=.876
Present Values
-100
3 3 .5 0 4 5
.8 0
2 6 .2 8
NPV = 5.58 or $5,580
4. EFFECTS OF INFLATION ON CASH FLOWS
Often there is a tendency to assume erroneously that, when, both net revenues and the project cost rise
proportionately, the inflation would not have much impact. These lines of arguments seem to be convincing, and it is
correct for two reasons. First, the rate used for discounting cash flows is generally expressed in nominal terms. It
would be inappropriate and inconsistent to use a nominal rate to discount cash flows which are not adjusted for the
impact of inflation. Second, selling prices and costs show different degrees of responsiveness to inflation. Estimating
the cash flows is a constant challenge to all levels of financial managers. To examine the effects of inflation on cash
flows, it is important to note the difference between nominal cash flow and real cash flow. It is the change in the
general price level that creates crucial difference between the two. A nominal cash flow means the income received in
terms rupees. On the other hand, a real cash flow means purchasing power of your income. The manager invested
Rs.10000 in anticipation of 10 per cent rate of return at the end of the year. It means that the manager will get
Rs.11000 after a year irrespective of changes in purchasing power of money towards goods or services. The sum of
Rs.11000 is known as nominal terms, which includes the impact of inflation. Thus, Rs. 1000 is a nominal return on
investment of the manager. On the other hand, (Let us assume the inflation rate is 5 per cent in next year. Rs.11000
next year and Rs.10476.19 today are equivalent in terms of the purchasing power if the rate of inflation is 5 per cent.)
Rs.476.19 is in real terms as it adjusted for the effect of inflation. Though the manager's nominal rate of return is Rs.
1000, but only Rs. 476 is real return. Therefore, the finance manager should be consistent in treating inflation as the
discount rate is market determined. In addition to this, a company's output price should be more than the expected
inflation rate. Otherwise there is every possibility to forego the good investment proposal, because of low profitability.
And also, future is always unexpected, what will be the real inflation rate (may be more or less). Thus, in estimating
cash flows, along with output price, expected inflation must be taken into account. In dealing with expected inflation
in capital budgeting analysis, the finance manager has to be very careful for correct analysis. A mismatch can cause
significant errors in decision-making.
5. EFFECTS OF INFLATION ON DISCOUNT RATE
Using of proper discount rate, depends on whether the benefits and costs are measured in real or nominal terms.
To be consistent and free from inflation bias, the cash flows should match with discount rate. Considering the above
example, 10 per cent is a nominal rate of return on investment of the manager. On the other hand, (Let us assume the
inflation rate is 5 per cent, in next year), though the manager's nominal rate of return is 10 per cent, but only 4.76
percent is real rate of return. In order to receive 10 per cent real rate of return, in view of 5 per cent expected inflation
rate, the nominal required rate of return would be 15.5%. The nominal discount rate (r) is
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Monika Gulia / VSRD International Journal of Business & Management Research Vol. 2 (4), 2012
a combination of real rate (K), expected inflation rate (?). This relationship is known as Fisher's effect, which
may be stated as follows:
r
k t
6. CONCLUSION
It could be inferred from the above analysis that, effects of inflation are significantly influenced on capital
budgeting decision making process. Though the inflation is a common problem, every finance manager encounters
during their capital budgeting decision making process for optimum utilisation of scarce resources especially in two
major aspects namely cash flow and discount rate. To examine the effects of inflation on cash flows, it is important to
note the difference between nominal cash flow and real cash flow. It is the change in the general price level that creates
crucial difference between these two. Therefore, the finance manager should take into cognizance the effect of
inflation. Otherwise possibilities are more to forego the good investment proposal, because of low profitability.
Moreover, inflation and capital budgeting are inseparable and a project can be successfully taken to completion
if all the hindrances are minimized, if not eliminated. Inflation eats away the values of our assets and it should be
adequately compensated for.
It can be determined from the above analysis; effects of inflation significantly influence the capital budgeting
decision making process. If the prices of outputs and the discount rates are expected to rise at the same rate, capital
budgeting decision will not be neutral. The implications of expected rate of inflation on the capital
budgeting process and decision making are as follows:
The company should raise the output price above the expected rate of inflation. Unless it has lower Net
Present Value which may lead to forego the proposals and vice versa.
If the company is unable to raise the output price, it can make some internal adjustments through careful
management of working capital.
With respect of discount rate, the adjustment should be made through capital structure.
7. FUTURE SCOPE
As the inflationary pressures keep on increasing the raw material for the further production also becomes costly,
so impact of inflation on working capital management decisions can be a good area of research.
Also, as the raw material becomes costly what can be the impact on the substitute or complementary goods like
if bread is costly, what will be impact on demand and prices of butter. In this area the scope of study can be for
Financial Economics or working capital management.
As the inflation impacts capital budgeting decisions so, it does impacts our initial calculation on cash inflows
and outflows. So, in that case how our discounting factor can increase or decrease the discounting value of
Page 165 of 166
Monika Gulia / VSRD International Journal of Business & Management Research Vol. 2 (4), 2012
future cash inflows, it can also be good area of research.
8. REFERENCES
[1] Alfred Rappaport and Robert A. Taggart, Jr., "Evaluation of Capital Expenditure Proposals Under
Inflation," Financial Management, Spring 1982, pp. 5-13.
[2] Aswath Damodaran (2001), " Corporate Finance-Theory and Practice", 2
nd
Edition, John Wiley & sons
(Asia), Pte Limited, Singapore, pp 318-324
[3] Ahuja K , " Macro Economics", 2nd Edition, S.Chand & Company Limited, New Delhi, pp 346-353
[4] W Carl Kester, Richard S Ruback & Peter Tufano , "Case problems in Finance", 12
th
Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi, pp. 419-430
[5] Bruner F. Robert, Case Studies in Finance, 5
th
Edition, Tata McGraw-Hill Publishing Company limited,
New Delhi, pp. 317-324
[6] Douglas Joines, "Short Term Interest Rates as Predictors of Inflation: A Comment," American Economic
Review, June 1977, pp. 476-77.
[7] John C. Woods and Maury R. Randall, "The Net Present Value of Future Investment Opportunities: Its
Impact on Shareholder Wealth and Implications for Capital Budgeting Theory," Financial Management, Summer
1989, pp. 85-92.
[8] Khan M Y and Jain P K, Financial Management - Text and Problems, 3
rd
Edition, Tata McGraw-Hill
Publishing Company limited, New Delhi, pp. 5.3 - 5.8
[9] Phillip L. Cooley, Rodney L. Roenfeldt, and It-Keong Chew, "Capital Budgeting Procedures Under
Inflation," Financial Management, Winter 1975, pp. 12-17.
[10] Ross Stephen A., Westerfield W. Randolph and Jaffe Jeffrey , Corporate Finance, 4
th
Edition, The McGraw
Hill Companies Inc., USA, pp. 174-179
[11] Pandey I.M. and Bhat Ramesh, Cases in Financial Management, Tata McGraw-Hill Publishing Company
limited, New Delhi, pp. 218-222
[12] Rustagi R. P., Financial Management - Theory, concepts and problems, 2
nd
revised edition, Galgotia
Publishing Company, New Delhi, pp. 520-525
[13] Sachdeva Amit, Macro Economics - 2009 Edition, Kusum Lata Publications, Delhi, pp. 8.26 - 8.32.
Page 166 of 166
doc_476050591.docx
A major impact on financial theory and the practice of financial decision making has been the economic instability, especially in prices, evidenced in the U.S. economy since the mid 1960’s.
Impact of Inflation on Capital Budgeting
Decisions : An Empirical Study
ABSTRACT
A major impact on financial theory and the practice of financial decision making has been the economic
instability, especially in prices, evidenced in the U.S. economy since the mid 1960's. Inflation in the past few years
has not been a major macroeconomic problem, but its spectre, as demonstrated by the Fed's recent increases in interest
rates, is never for the agendas of financial decision makers. Macro economic instability has necessitated that
expectations about the future rate of inflation be taken into consideration in making decisions about which capital
projects will be undertaken by a firm. Nominal cash flows determine its degree of profitability. However, in making
the capital budgeting decision both real and nominal concepts must be considered. The purpose of this paper is to
continue the discussion of the role of inflation in capital budgeting, and to focus on the individual components of the
process to draw specific conclusions with respect to the
interaction between the cost of capital, inflation, and the cash flow variables within a DCF -IRR framework.
Keywords : Financial Decision Making, Inflation, Macro Economic I nstability, Capital Budgeting Decisions.
1. INTRODUCTION
In today's complex business environment, making capital budgeting decisions are among the most important
and multifaceted of all management decisions as it represents major commitments of company's resources and have
serious consequences on the profitability and financial stability of a company. It is important to evaluate the proposals
rationally with respect to both the economic feasibility of individual projects and the relative net benefits of alternative
and mutually exclusive projects. It has inspired many research scholars and is primarily concerned with sizable
investments in long-term assets, with long-term life.
The growing internationalisation of business brings stiff competition which requires a proper evaluation and
____________________________
1
Research
2
Assistant
Scholar, MBA Department, Manav Bharti University, Solan, Himanchal Pradesh, INDIA.
Professor, MBA Department, Delhi Institute of Advanced Studies, Rohini, New Delhi, INDIA.
*Correspondence : [email protected]
Monika Gulia / VSRD International Journal of Business & Management Research Vol. 2 (4), 2012
weightage on capital budgeting appraisal issues viz. differing project life cycle, impact of inflation, analysis and
allowance for risk. Therefore financial managers must consider these issues carefully when making capital budgeting
decisions. Inflation is one of the important parameters that govern the financial issues on capital budgeting decisions.
Managers evaluate the estimated future returns of competing investment alternatives. Some of the alternatives
considered may involve more risk than others. For example, one alternative may fairly assure future cash flows,
whereas another may have a chance of yielding higher cash flows but may also result in lower returns. It is because,
apart from other things, inflation plays a vital role on capital budgeting decisions and is a common fact of life all over
the world. Inflation is a common problem faced by every finance manager which complicates the practical investment
decision making than others. Most of the managers are concerned about the effects of inflation on the project's
profitability. Though a double digit rate of inflation is a common feature in developing countries like India, the manager
should consider this factor carefully while taking such decisions.
In practice, the managers do recognize that inflation exists but rarely incorporate inflation in the analysis of
capital budgeting, because it is assumed that with inflation, both net revenues and the project cost will rise
proportionately, therefore it will not have much impact. However, this is not true; inflation influences two aspects viz.
Cash Flow and Discount Rate.
A major impact on both financial theory and the practice of financial decision making has been the economic
instability, especially in prices, evidenced in the U.S. economy since the mid 1960's. Inflation in the past few years has
not been a major macroeconomic problem, but its spectre, as demonstrated by the Fed's recent increases in interest
rates, is never for the agendas of financial decision makers. Macro economic instability has necessitated that
expectations about the future rate of inflation be taken into consideration in making decision(s) about which capital
projects will be undertaken by a firm. Nominal cash flows determine its degree of profitability. However, in making
the capital budgeting decision both real and nominal concepts must be considered. The purpose of this paper is to
continue the discussion of the role of inflation in capital budgeting, and to focus on the individual components of the
process to draw specific conclusions with respect to the
interaction between the cost of capital, inflation, and the cash flow variables within a DCF -IRR framework.
2. CAPITAL BUDGETING AND INFLATION
Capital budgeting or investment appraisal is a process which anticipates expenses pertaining to assets as well as
cash flows in the future. Investment appraisal takes into account the various factors which impact expenditure in the
long run. Inflation is one such factor, which impacts investments and returns.
Inflation and capital budgeting are closely related and at no cost capital budgeting can be completed without
taking into account inflation. It is a known fact that inflation causes our purchasing power to decline. So, if we buy an
asset for $ 5,000 today, it is probable that the same asset can be bought for $ 10,000 after a couple of years. However,
it is assumed that the project cost as well as net revenues increase in a proportionate manner with inflation. For this
reason, in reality rates of inflation are not taken into account. But this is not true always, inflation does affect capital
budgeting. Inflation and capital budgeting are bound to affect cash flows.
Page 160 of 166
Monika Gulia / VSRD International Journal of Business & Management Research Vol. 2 (4), 2012
3. EFFECTS OF INFLATION ON CAPITAL BUDGETING
Inflation affects discount rates and cash flows. There are two factors on which inflation acts. They are discount
rate and cash flow.
3.1. Cash Flows
Let us assume that r refers to the revenues; t refers to the tax rate; c is the cost and d is the depreciation. By
arranging the above variables in a formula, the following is obtained.
r c t d r
c t dt
Inflation affects (r-c) (1-t), which is on the right side of the equation. But Inflation does not impact dt. The
reason can be attributed to the fact that historical costs determine depreciation costs. This implies that inflation has a
tendency to decrease the value of real rate of return. Studies reveal that Net cash flow is more as compared to real cash
flows provided we do not take inflation into account.
3.2. Discount Rates
Discount rates refer to the rate of return, which is the required rate or the target rate. The project cost is inflation
adjusted. This adjustment is usually done in the premiums. The required rate or the target rate of return for the
investors ought to be the same as real inflation return together with the expected inflation rate.
3.2.1. Case 1: Does inflation impact capital budgeting analysis?
The answer is a qualified yes, i.e., inflation does have an impact on the numbers that are used in capital
budgeting analysis. But it does not have impact on the results of the analysis if certain conditions are satisfied. To
show what we mean by this statement, we will use the following data.
For instance, Martin Company wants to purchase a new machine that costs $36,000. The machine would
provide annual cost savings of $20,000, and it would have a three-year life with no salvage value. For each of the next
three years, the company expects a 10% inflation rate in the cash flows associated with the new
machine. If the company's cost of capital is 23.2%, should the new machine be purchased?
To answer this question, it is important to know how the cost of capital was derived. Ordinarily, it is based on
the market rates of return on the company's various sources of financing - both debt and equity. This market rate of
return includes expected inflation; the higher the expected rate of inflation, the higher the market rate of return on debt
and equity. When the inflationary effect is removed from the market rate of return, the result is called a real rate of
return. For example, if the inflation rate of 10% is removed from the Martin's cost of
capital of 23.2% the real cost of capital is only 12% as shown below:
Case 1: Martin Company
Reconciliation of the Market-Based and Real Costs of Capital
The real cost of capital 1 2 .0 %
The inflation factor 1 0 .0
The combined effect (12% 10% = 1.2%) 1 .2
Page 161 of 166
Monika Gulia / VSRD International Journal of Business & Management Research Vol. 2 (4), 2012
The market based cost of capital 2 3 .2 %
Solution A: Inflation Not Considered:
Present
Amount of Value of
Item Year(s) Cash Flows 12% Factor Cash Flows
Initial investment Now $(36,000) 1 .0 0 0 $(36,000)
Annual cost savings 1-3 20,000 2 .4 0 2 48,040
Net present value $12040*
Solution B: Inflation Considered:
Price Present
Amount of Price Index Adjusted 2 3 .2 % Value of
Item Year(s) Cash Flows Number** Cash Flows Factor*** Cash Flows
Initial
investment
Annual cost
savings
Net present
value
Now
1
2
3
$(36,000)
20,000
20,000
20,000
1 .0 0 0
1 .1 0 0
1 .2 1 0
1 .3 3 1
$(36,000)
22,000
24,200
26,620
1 .0 0 0
0 .8 1 2
0 .6 5 9
0 .5 3 5
$(36,000)
17,864
15,948
14,242
$12,054*
*These amounts are different only because of rounding errors
**Computation of the price inde3x numbers, assuming a 10% inflation rate each year: Year 1, (1.10) = 1.10; Year
2, (1.10)
2
= 1.21; Year 3, (1.10) = 1.331
***Discount formulas are computed using the formula 1/(1 + r)
n
, where r is the discount factor and n is the
number of years. The computations are 1/1.232 = 0.812 for year 1; 1/(1.232)
2
= 0.659 for year 2; and 1/(1.232)
3
=
0.535 for year 3.
One cannot simply subtract the inflation rate from the market cost of capital to obtain the real cost of capital.
The computations are bit more complex than that.
When performing a net present value analysis, one must be consistent. The market based cost of capital reflects
inflation. Therefore, if a market based cost of capital is used to discount cash flows, then the cash flows should be
adjusted upwards to reflect the effects of inflation in forthcoming periods. Computations of Martin Company under this
approach are given in solution B Above.
On the other hand, there is no need to adjust the cash flows upward if the "real cost of capital" is used in the
analysis (Since the inflationary effects have been taken out of the discount rate). Computation for the Martin Company
under this approach is given in solution A above. Note that under solution A and B the answer will be same (within
rounding error) regardless of which approach is used, so long as one is consistent and all of the cash flows associated
with the project are affected in the same way by inflation.
Several points need to be noted about solution B, where the effects of inflation are explicitly taken into account.
First, not that the annual cost savings are adjusted for the effects of inflation by multiplying each year's cash savings
by a price index number that reflects a 10% inflation rate (Observe from the foot notes to the solution how the index
number is computed for each year). Second, note that the net present value obtained in solution B, where inflation is
explicitly taken into account, is the same, within rounding error, to that obtained in solution A, where the inflation
effects are ignored. This result may seem surprising, but it is logical. The reason is that we have adjusted both the cash
flows and the discount rate so that they are consistent, and these adjustments cancel each other out across the two
solutions.
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3.2.2. Case 2: How Does Inflation Impact Capital Budgeting?
The accuracy of capital budgeting decisions depends on the accuracy of the data regarding cash inflows and
outflows. For example, failure to incorporate price-level changes due to inflation in capital budgeting situations can
result in errors in the predicting of cash flows and thus, in incorrect decisions.
What are the ways in which to incorporate price-level changes into capital budgeting decision?
Typically, an analyst has two options when dealing with a capital budgeting situation with inflation: (1) either
restate the cash flows in nominal terms and discount them at a nominal cost of capital (minimum required rate of
return), or (2) restate both the cash flows and cost of capital in constant terms and discount the constant cash flows at a
constant cost of capital. The two methods are basically equivalent.
For instance, a company has the following projected cash flows estimated in real terms:
Real Cash Flows (000s)
Period 0 1 2 3
-100 35 50 30
The nominal cost of capital is 15%. Assume that inflation is projected at 10% a year. Then the first cash flow for
year 1, which is $35,000 in current dollars, will be 35,000 x 1.10 = $38,500 in year 1 dollars. Similarly, the cash flow
for year 2 will be 50,000 x (1.10)
2
=$60,500 in year 2 dollars, and so on. If one discounts these nominal cash flows at
the 15% nominal cost of capital, one has the following net present value (NPV) in thousands of
dollars:
Period
0
1
2
3
Cash Flows
-100
3 8 .5 6
0 .5
3 9 .9
T3
1
0 .8 7 0
0 .7 5 6
0 .6 5 8
Present Values
-100
3 3 .5 0 4 5 .7
4
2 6 .2 5
NPV = 5.49 or $5,490
Instead of converting the cash-flow forecasts into nominal terms, one could convert the cost of capital into real
terms by using the following formula: Real cost of capital =1 + nominal cost of capital)/(1 + inflation rate)- 1
In the example, this gives:
Real cost of capital = (1 + .15)/(1 + .10) - 1
= 1.15/1.10 - 1
= 1.045 - 1
= .0 4 5 o r 4 .5 %
One will obtain the same answer except for rounding errors ($5,490 vs. $5,580).
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Period
0
1
2
3
Cash Flows
-100
35
50
30
T3 = 1/(1 + .045)n
1
1/(1+.045)=.957
1/(1.045)2=.916
1/(1.045)3=.876
Present Values
-100
3 3 .5 0 4 5
.8 0
2 6 .2 8
NPV = 5.58 or $5,580
4. EFFECTS OF INFLATION ON CASH FLOWS
Often there is a tendency to assume erroneously that, when, both net revenues and the project cost rise
proportionately, the inflation would not have much impact. These lines of arguments seem to be convincing, and it is
correct for two reasons. First, the rate used for discounting cash flows is generally expressed in nominal terms. It
would be inappropriate and inconsistent to use a nominal rate to discount cash flows which are not adjusted for the
impact of inflation. Second, selling prices and costs show different degrees of responsiveness to inflation. Estimating
the cash flows is a constant challenge to all levels of financial managers. To examine the effects of inflation on cash
flows, it is important to note the difference between nominal cash flow and real cash flow. It is the change in the
general price level that creates crucial difference between the two. A nominal cash flow means the income received in
terms rupees. On the other hand, a real cash flow means purchasing power of your income. The manager invested
Rs.10000 in anticipation of 10 per cent rate of return at the end of the year. It means that the manager will get
Rs.11000 after a year irrespective of changes in purchasing power of money towards goods or services. The sum of
Rs.11000 is known as nominal terms, which includes the impact of inflation. Thus, Rs. 1000 is a nominal return on
investment of the manager. On the other hand, (Let us assume the inflation rate is 5 per cent in next year. Rs.11000
next year and Rs.10476.19 today are equivalent in terms of the purchasing power if the rate of inflation is 5 per cent.)
Rs.476.19 is in real terms as it adjusted for the effect of inflation. Though the manager's nominal rate of return is Rs.
1000, but only Rs. 476 is real return. Therefore, the finance manager should be consistent in treating inflation as the
discount rate is market determined. In addition to this, a company's output price should be more than the expected
inflation rate. Otherwise there is every possibility to forego the good investment proposal, because of low profitability.
And also, future is always unexpected, what will be the real inflation rate (may be more or less). Thus, in estimating
cash flows, along with output price, expected inflation must be taken into account. In dealing with expected inflation
in capital budgeting analysis, the finance manager has to be very careful for correct analysis. A mismatch can cause
significant errors in decision-making.
5. EFFECTS OF INFLATION ON DISCOUNT RATE
Using of proper discount rate, depends on whether the benefits and costs are measured in real or nominal terms.
To be consistent and free from inflation bias, the cash flows should match with discount rate. Considering the above
example, 10 per cent is a nominal rate of return on investment of the manager. On the other hand, (Let us assume the
inflation rate is 5 per cent, in next year), though the manager's nominal rate of return is 10 per cent, but only 4.76
percent is real rate of return. In order to receive 10 per cent real rate of return, in view of 5 per cent expected inflation
rate, the nominal required rate of return would be 15.5%. The nominal discount rate (r) is
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a combination of real rate (K), expected inflation rate (?). This relationship is known as Fisher's effect, which
may be stated as follows:
r
k t
6. CONCLUSION
It could be inferred from the above analysis that, effects of inflation are significantly influenced on capital
budgeting decision making process. Though the inflation is a common problem, every finance manager encounters
during their capital budgeting decision making process for optimum utilisation of scarce resources especially in two
major aspects namely cash flow and discount rate. To examine the effects of inflation on cash flows, it is important to
note the difference between nominal cash flow and real cash flow. It is the change in the general price level that creates
crucial difference between these two. Therefore, the finance manager should take into cognizance the effect of
inflation. Otherwise possibilities are more to forego the good investment proposal, because of low profitability.
Moreover, inflation and capital budgeting are inseparable and a project can be successfully taken to completion
if all the hindrances are minimized, if not eliminated. Inflation eats away the values of our assets and it should be
adequately compensated for.
It can be determined from the above analysis; effects of inflation significantly influence the capital budgeting
decision making process. If the prices of outputs and the discount rates are expected to rise at the same rate, capital
budgeting decision will not be neutral. The implications of expected rate of inflation on the capital
budgeting process and decision making are as follows:
The company should raise the output price above the expected rate of inflation. Unless it has lower Net
Present Value which may lead to forego the proposals and vice versa.
If the company is unable to raise the output price, it can make some internal adjustments through careful
management of working capital.
With respect of discount rate, the adjustment should be made through capital structure.
7. FUTURE SCOPE
As the inflationary pressures keep on increasing the raw material for the further production also becomes costly,
so impact of inflation on working capital management decisions can be a good area of research.
Also, as the raw material becomes costly what can be the impact on the substitute or complementary goods like
if bread is costly, what will be impact on demand and prices of butter. In this area the scope of study can be for
Financial Economics or working capital management.
As the inflation impacts capital budgeting decisions so, it does impacts our initial calculation on cash inflows
and outflows. So, in that case how our discounting factor can increase or decrease the discounting value of
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future cash inflows, it can also be good area of research.
8. REFERENCES
[1] Alfred Rappaport and Robert A. Taggart, Jr., "Evaluation of Capital Expenditure Proposals Under
Inflation," Financial Management, Spring 1982, pp. 5-13.
[2] Aswath Damodaran (2001), " Corporate Finance-Theory and Practice", 2
nd
Edition, John Wiley & sons
(Asia), Pte Limited, Singapore, pp 318-324
[3] Ahuja K , " Macro Economics", 2nd Edition, S.Chand & Company Limited, New Delhi, pp 346-353
[4] W Carl Kester, Richard S Ruback & Peter Tufano , "Case problems in Finance", 12
th
Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi, pp. 419-430
[5] Bruner F. Robert, Case Studies in Finance, 5
th
Edition, Tata McGraw-Hill Publishing Company limited,
New Delhi, pp. 317-324
[6] Douglas Joines, "Short Term Interest Rates as Predictors of Inflation: A Comment," American Economic
Review, June 1977, pp. 476-77.
[7] John C. Woods and Maury R. Randall, "The Net Present Value of Future Investment Opportunities: Its
Impact on Shareholder Wealth and Implications for Capital Budgeting Theory," Financial Management, Summer
1989, pp. 85-92.
[8] Khan M Y and Jain P K, Financial Management - Text and Problems, 3
rd
Edition, Tata McGraw-Hill
Publishing Company limited, New Delhi, pp. 5.3 - 5.8
[9] Phillip L. Cooley, Rodney L. Roenfeldt, and It-Keong Chew, "Capital Budgeting Procedures Under
Inflation," Financial Management, Winter 1975, pp. 12-17.
[10] Ross Stephen A., Westerfield W. Randolph and Jaffe Jeffrey , Corporate Finance, 4
th
Edition, The McGraw
Hill Companies Inc., USA, pp. 174-179
[11] Pandey I.M. and Bhat Ramesh, Cases in Financial Management, Tata McGraw-Hill Publishing Company
limited, New Delhi, pp. 218-222
[12] Rustagi R. P., Financial Management - Theory, concepts and problems, 2
nd
revised edition, Galgotia
Publishing Company, New Delhi, pp. 520-525
[13] Sachdeva Amit, Macro Economics - 2009 Edition, Kusum Lata Publications, Delhi, pp. 8.26 - 8.32.
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