Capital Budgeting and the Treatment of Inflation

Forecasts Spread Over a Period of Time

Inflation is an ever persistent condition in today’s economy. The purchasing power of money has been reducing year after year for decades now. Apart from the occasional recession where money may gain real value, the usual case is a loss of value. Investors are investing money today. They want to be compensated for the inflation and still get a return over and above it. This simply means that they want to gain value in real terms.

It is important for us to understand this while coming up with our cash flow estimations. This is because projects never give all of their cash flows in the same period. Cash flows from projects are usually spread out over many years, even decades. The treatment of inflation therefore becomes very important to come up with the correct value.

Minor changes in the assumptions about inflation are capable of producing massive changes in the expected return from the project. A viable project may become unviable simply by tweaking the inflation numbers a little bit. This article will explain how inflation needs to be treated while performing these calculations:

Inflation Affects Different Components Differently

First, we need to understand that inflation never affects all the components of the income statement uniformly. Therefore assuming a uniform rate for all the components might give theoretically correct answers, but in practical life it will be a blunder.

For instance, consider the fact that labor costs will go up every year. Employees usually expect to be paid a hike every year. Also, the cost of raw materials is expected to go up every year.

Tax rates change every year. However, the increase in sales price cannot match these changes. It will usually be either more or less than the percentage change in other components. Sales price is market driven and we can’t just raise it without incurring any loss.

The bottom line therefore is that a good analyst will study the past record of each of these components in terms of their inflationary tendency. He/she will then try to make forecasts about the future trends that are likely to prevail. Based on this, every component should have its own unique rate of inflation. In more detailed analyses, inflation forecasts will vary year to year depending on how the analyst predicts the economy to behave.

The Golden Rule

The golden rule when it comes to capital budgeting and inflation is that we must be consistent in our treatments of inflation. The keyword is consistency. If we have real cash-flows, we must discount them at the real rate of interest. On the other hand, if we have nominal cash flows (usually the case), we must discount them at a nominal rate of interest. This might seem obvious, but is a common mistake to use the wrong discount rate.

We have earlier studied a formula to convert nominal rates to real rates and vice versa. The formula is as follows:

(1 + nominal rate) = (1 + real rate) * (1 + inflation rate)

An Approximation to the Golden Rule

This formula maybe required if you are doing precise calculations. If the intent is to come up with an approximate figure, simple back of the hand calculations will suffice. Hence, if the nominal rate is stated at 12% and the inflation rate is stated at 4%, it is a reasonable assumption to assume 4% as the real rate of return. Obviously the resultant numbers will not be precise but they will provide a good approximation which is exactly what is required sometimes.

Despite all the forecasting techniques and calculations, analysts are usually way off the mark when it comes to predicting inflation rates. This is not because of their shortcomings but rather because of the unpredictable nature of the economy. Nonetheless, they try to refine their methods time and again in the quest to get the inflation numbers right.