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8/6/2019 Acb III Inflation
http://slidepdf.com/reader/full/acb-iii-inflation 1/15
INVESTMENT
DECISIONS
UNDER INFLATION
8/6/2019 Acb III Inflation
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INVESTMENT DECISIONS UNDER
INFLATION
A common problem which complicates the
practical investment decision making is
inflation.
The cash flows of an investment project occur
over a long period of time, so the firm should
usually be concerned about the impact of
inflation on the project¶s profitability.
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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
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INFLATION EFFECTS TWO ASPECTS OF
CAPITAL BUDGETING
PROJECTED CASH FLOWS
DISCOUNT RATE
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INVESTMENT DECISIONS UNDER
INFLATION
Business executives recognize that inflation
exists but they do not consider it necessary
to incorporate inflation in the analysis
because of two arguments-
1. If there is inflation, prices can be increased
to cover increasing costs.
2. The discount rate is expressed in nominalterms.
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INVESTMENT DECISIONS UNDER
INFLATION
Effects ± Bias in cash flow estimation
Cost are sensitive to inflation.
Some aspects are unaffected by inflation like
depreciation tax shield
Working capital may also increase by
inflation.
Salvage value may also be affected.
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INVESTMENT DECISIONS UNDER
INFLATION
Use of nominal discount rate to discount real
cash flows.
Use of real discount rate to discount nominal
cash flows.
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REAL AND NOMINAL RATES
Real interest rates and cash flows do not
include inflation effects.
Nominal interest rates and cash flows do
reflect inflation.
In the absence of inflation, the real rate will
be equal to the nominal rate. Moreover, nominal cash flow (NCF) and Real
cash flow (RCF) are also equal
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REAL AND NOMINAL RATES
In absence of inflation, NPV is as follows-
NPV (No inflation)=
n�NCFt/(1+Kn)t = n�RCFt/(1+Kr)t =
t= 0 t= 0
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REAL AND NOMINAL RATES
Suppose inflation exists, then cash flows
raise at
NCF=RCF(1+i)t
(1+Kn)= (1+Kr) (1+i)
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REAL AND NOMINAL RATES
So , with inflation,
n�NCFt/(1+Kn)t = n�RCFt (1+i)t / (1+Kr)t (1+i)t
t= 0 t= 0
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REAL AND NOMINAL RATES
The opportunity cost of capital of a firm is
market determined and based on expected
future returns.
Therefore, it is expressed in nominal termsand reflects the expected rate of inflation.
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REAL AND NOMINAL RATES
So opportunity cost of capital is a combination
of real rate and inflation.
This relationship is called fisher¶s effect
Nominal int.rate = (1+real rate)(1+inflation)-1
K=(1+k)(1+)-1
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The Fisher Effect model says nominal interest
rates reflect the real rate of return and
expected rate of inflation. So the difference
between real and nominal rates of interest isdetermined by expected rates of inflation.
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The approximate nominal rate of return = realrate of return plus the expected rate of inflation.
For example, if the real rate of return is 3.5%and expected inflation is 5.4 % then theapproximate nominal rate of return is 0.035 +0.054.= 0.089 or 8.9%.
The precise formula is (1 + nominal rate) = (1+ real rate) x (1 + inflation rate), which wouldequal 9.1% in this example.