Chapter 10 -- Inflation and Capital
Investment Analysis
Why
is inflation important?
Expected
inflation is in the discount rate
(WACC) that is used to calculate the net
present value of a project, so it must also be
included in the cash flow projections.
Inflation and Capital Investment
Analysis
 Adjusting
current dollars to constant dollars
 Constant dollars= Current price / (PIt/ PIb)
Inflation and Capital Investment
Analysis
 Real
rates of return
 Real rates do not include inflation.
 We cannot observe real rates, but we can
“estimate” what real rates might have been in
prior periods.
 We observe nominal, market or quoted rates.
These rates do include expected inflation.
Inflation and Capital Investment
Analysis – Timing of the impact
 Income
and consequently cash flow may or may not be affected
immediately by inflation.
 Inflation may increase the revenue stream before, during or
after the cost stream.
 The competitiveness of the industry has an impact on how
quickly the impact of inflation is reflected in income and cash
flow.
 Inventory can cause a delay in the pass through of cost
increases.
 The practice of annual raises may also delay the the increase.
Inflation and Capital Investment
Analysis – Size of the Impact
 Inflation
may not impact the revenue stream in the
same proportion as it does the cost stream
 The cost stream may be somewhat independent of
the supply and demand characteristics in the
finished product market.
 Examples – Tires, Personal Computers, Cereal
 The competitiveness of the industry also has an
impact on how much of the cost streams inflation
or deflation is reflected in income and cash flow.
Inflation and Capital Investment
Analysis
 While
inflation may or may not change income…
 an increase in the cost stream may cause an
increase in the investment in working capital and a
decrease in cash flows
 an increase in price will cause and increase in
working capital (accounts receivable).
Inflation and Capital Investment
Analysis
 Because
depreciation and some inventory methods
are based on historical cost rather than replacement
cost…
 taxable income may increase (while being used
for additional working capital)
 cash payments for taxes may increase
 therefore lowering cash flows
Inflation and Capital Investment
Analysis
 By
locking in interest rates on the debt used to
finance a portion of the project, inflation may
increase the wealth created by the project.
 Empirical studies have shown that during recent
periods of high inflation the value of common stock,
on average, has declined with increases in inflation.
 The equivalent annuity method, adjusted for
inflation, can be used for choosing between mutually
exclusive projects in the same way that it was used
without inflation.