INFLATION AND CAPITAL
BUDGETING
• INFLATION IS THE INCREASE IN THE
GENERAL LEVEL OF PRICES FOR ALL
GOODS AND SERVICES IN AN
ECONOMY
NOMINAL VS. REAL
• NOMINAL VALUES ARE THE ACTUAL
AMOUNT OF MONEY MAKING UP CASH
FLOWS
• REAL VALUES REFLECT THE PURCHASING
POWER OF THE CASH FLOWS
• REAL VALUES ARE FOUND BY ADJUSTING
THE NOMINAL VALUES FOR THE RATE OF
INFLATION
• INFLATION EFFECTS TWO ASPECTS
OF CAPITAL BUDGETING
– PROJECTED CASH FLOWS
– DISCOUNT RATE
• IF PROJECTED CASH FLOWS ARE IN
REAL TERMS (WITHOUT INFLATION
CONSIDERED) THE DISCOUNT RATE
USED SHOULD BE A REAL RATE.
• IF PROJECTED CASH FLOWS ARE IN
NOMINAL TERMS (WITH INFLATION
CONSIDERED) THE DISCOUNT RATE
USED SHOULD BE A NOMINAL RATE.
• BOTH THE PAYMENT SERIES AND
THE DISCOUNT RATE MUST BE
SPECIFIED EITHER IN NOMINAL
VALUES OR IN REAL VALUES, BUT
NOT IN BOTH VALUES
CONCURRENTLY.
Is it better to use real or nominal values?
• Using nominal values is more common.
• Market interest rates are nominal values that
already contain a premium for anticipated
inflation.
• Income tax obligations are based on nominal
values.
• Therefore, it is usually easier to use nominal
values.
• However, if a nominal discount rate is used,
projected cash flows should reflect anticipated
inflation.
RISK AND CAPITAL
BUDGETING
• RISK PERTAINS TO THE POSSIBILITY
THAT THE PROJECTED CASH FLOWS
WILL BE LESS THAN ESTIMATED.
METHODS OF ACCOUNTING FOR RISK
IN CAPITAL BUDGETING ARE:
• ADJUSTING THE DISCOUNT RATE TO
REFLECT A RISK PREMIUM.
• CONVERTING THE PAYMENT SERIES
TO CERTAINTY EQUIVALENTS.
• PROBABILITY ANALYSIS.
ADJUSTING THE DISCOUNT RATE
• DISCOUNT RATE COMPONENTS
INCLUDE:
– TIME PREFERENCE
– INFLATION EXPECTATIONS
– RISK PREMIUM
• THE RISK PREMIUM IS THE COST OF
RISK BEARING.
• INCREASING THE DISCOUNT RATE
ADDS A COST FOR TAKING RISK BY
REQUIRING A HIGHER RATE OF
RETURN FOR RISK BEARING.
CERTAINTY EQUIVALENT
APPROACH
• ADJUSTS THE CASH FLOWS TO A
LEVEL WITH A HIGHER “CERTAINTY”
THAT THEY WILL BE RECEIVED.
• CONCEPTUALLY SIMILAR TO A RISK
PREMIUM.
PROBABILITY ANALYSIS
• DETERMINES AN EXPECTED CASH
FLOW AND ITS ASSOCIATED
PROBABILITY OF OCCURRING.
• DERIVE A PROBABILITY WEIGHTED
EXPECTED RETURN.
• USE THE WEIGHTED CASH FLOW
ESTIMATE
COMPARING INVESTMENTS WITH
DIFFERENT ECONOMIC LIVES
• WHEN COMPARING INVESTMENTS
WITH DIFFERENT ECONOMIC LIVES
THE NET PRESENT VALUES ARE NOT
DIRECTLY COMPARABLE.
• ONE METHOD TO ADJUST FOR
UNEQUAL PLANNING HORIZONS IS
TO USE THE ANNUITY EQUIVALENT.
ANNUITY EQUIVALENT
• THE ANNUITY EQUIVALENT IS THE
PAYMENT THAT WOULD BE
NECESSARY TO ACHIEVE THE
PRESENT VALUE AT THE DISCOUNT
RATE AND TIME PERIOD OF THE
INVESTMENT.
• THE ANNUITY EQUIVALENT IS
FOUND BY TAKING THE NPV AS
CALCULATED FOR EACH
INVESTMENT ALTERNATIVE,
SETTING THE NPV AS THE PRESENT
VALUE USING THE SAME DISCOUNT
RATE AND TIME HORIZON, AND
SOLVING FOR THE PAYMENT.
• THE PAYMENT REPRESENTS THE
ANNUITY EQUIVALENT
ANNUITY EQUIVALENT
0
1
2
3
4
5
6
7
A
100000
20000
20000
20000
20000
20000
20000
20000
B
100000
26000
26000
26000
26000
26000
INVESTMENT “A”
•
•
•
•
•
CF0 = -100,000
CF1 = 20,000
F1 = 7
I = 8%
NPV = 4,127
INVESTMENT “B”
•
•
•
•
•
CF0 = -100,000
CF1 = 26,000
F1 = 5
I = 8%
NPV = 3,810
CALCULATION OF THE
ANNUITY EQUIVALENT
PV
I/Y
N
FV
P/Y
A
-4,427
8
7
0
1
B
-3,810
8
5
0
1
PMT (AE)
793
954