Inflation and Capital Budgeting Analysis


Inflation and Capital Budgeting Analysis:

Learning Objectives:

  1. Does inflation impact capital budgeting analysis? Explain.

Doesn’t inflation have an impact in a capital budgeting analysis? The answer is qualified yes in that 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.

Example:

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:

Capital Budgeting and Inflation

Reconciliation of the Market-Based and Real Costs of Capital
The real cost of capital 12.0%
The inflation factor

10.0

The combined effect (12%  10% = 1.2%) 1.2

The market based cost of capital

23.2%

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Solution A: Inflation Not Considered:
Item Year(s) Amount of Cash Flows 12% Factor Present Value of Cash Flows
Initial investment Now $(36,000) 1.000 $(36,000)
Annual cost savings 1 – 3 20,000 2.402 48,040


Net present value $12040*
=========
Solution B: Inflation Considered:
Item Year(s) Amount of Cash Flows Price Index Number** Price Adjusted Cash Flows 23.2%
Factor**
*
Present Value of Cash Flows
Initial investment Now $(36,000) 1.000 $(36,000) 1.000 $(36,000)
Annual cost savings 1 20,000 1.100 22,000 0.812 17,864
2 20,000 1.210 24,200 0.659 15,948
3 20,000 1.331 26,620 0.535 14,242

Net present value $12,054*
=========
*These amounts are different only because of rounding errors
**Computation of the price index 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)3 = 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.

You 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 rat). Computation of the martin under this approach are given in solution A above. Note that under solution A and B that the answer will be the 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 effected in the same way by inflation.

Several points should 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.

Throughout this section of the website (Capital Budgeting Decisions) we assume for simplicity that there is no inflation. In that case, the market-based and real costs of capital are the same, and there is no reason to adjust the cash flow for inflation since there is none. When there is inflation, the unadjusted cash flows can be used in the analysis if all of the cash flows are affected identically by inflation and the real cost of capital is used to discount the cash flows. Otherwise, the cash flows should be adjusted for inflation and the market-based cost of capital should be used in the analysis.

You may also be interested in other articles from “capital budgeting decisions” chapter:

  1. Capital Budgeting – Definition and Explanation
  2. Typical Capital Budgeting Decisions
  3. Time Value of Money
  4. Screening and Preference Decisions
  5. Present Value and Future Value – Explanation of the Concept
  6. Net Present Value (NPV) Method in Capital Budgeting Decisions
  7. Internal Rate of Return (IRR) Method – Definition and Explanation
  8. Net Present Value (NPV) Method Vs Internal Rate of Return (IRR) Method
  9. Net Present Value (NPV) Method – Comparing the Competing Investment Projects
  10. Least Cost Decisions
  11. Capital Budgeting Decisions With Uncertain Cash Flows
  12. Ranking Investment Projects
  13. Payback Period Method for Capital Budgeting Decisions
  14. Simple rate of Return Method
  15. Post Audit of Investment Projects

  16. Inflation and Capital Budgeting Analysis
  17. Income Taxes in Capital Budgeting Decisions
  18. Review Problem 1: Basic Present Value Computations
  19. Review Problem 2: Comparison of Capital Budgeting Methods
  20. Future Value and Present Value Tables

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