Acb III Inflation

8/6/2019 Acb III Inflation

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INVESTMENT

DECISIONS

UNDER INFLATION



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.



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




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.




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.




INFLATION

Use of nominal discount rate to discount real

cash flows.

Use of real discount rate to discount nominal

cash flows.



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




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




Suppose inflation exists, then cash flows

raise at

NCF=RCF(1+i)t

(1+Kn)= (1+Kr) (1+i)




So , with inflation,

n�NCFt/(1+Kn)t = n�RCFt (1+i)t / (1+Kr)t (1+i)t

t= 0 t= 0




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.




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



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.



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.

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Acb III Inflation