A common problem, which complicates the practical investment decision-making , is inflation, to be consistent in treating inflation in the cash flows and the discount rate.
Inflation is fact of life all over the world.A double -digit rate of inflation is a common feature in developing countries. Because the cash flows of an investment project occur over a long period of time, a firm should usually be concerned about the impact of inflation on the project’s profitability. The capital budgeting results will be biased if the impact of inflation is not correctly factored in the analysis.
Business executives do recognise that inflation exists but they do not consider it necessary to incorporate inflation in the analysis of capital investment. They generally estimate cash flows assuming unit costs and selling price prevailing in year zero to remain unchanged. They argue that if there is inflation prices can be increased to cover increasing costs.
The impact on the project’s profitability would be the same if they assume rate of inflation prices, can be increased to cover increasing costs; therefore , the impact on the projects’s profit ability would be the same if they assume rate inflation to zero. This line of argument although seems to be convincing , is fallacious for two reason.
1) The discount rate used for discounting cash flow is generally expressed in nominal terms. It would be inappropriate and inconsistent to use a nominal rate to discount constant cash flows. Pm
2) Selling prices and costs show different degrees of responsiveness to inflation. In the case of certain products, prices may be controlled by the government , or by restrictive competition , or there may exist a long-term contract to supply goods or services at fixed price.
However, some costs ride faster than others. For example wages may increase at a rate higher than, say fuel and power , or even raw material. The depreciation tax shield remains unaffected by inflation since depreciation us allowed on the book value of an asset, irrespective of its replacement or market price, for tax purposes.
The working capital tied up in an investment project may also increase during inflationary conditions. Because of the increasing input prices and manufacturing costs, more funds may have to be tied up in inventories and receivable . The salvage value of the project may also be affected by inflation.
Nominal Vs.Real Rates of Return
Suppose a person -we call him jose, deposits rs.100 in the state bank of india for one year at 10 percent rate of interest . This means that the bank agrees to return rs.110 to jose after a year , irrespective of how much goods or services this money can buy for him. The sum of. Rs.110 is stated in nominal terms .
The rs.110 is expressed in nominal terms since they have not been adjusted for the effect of inflation. On the other hand , the rs. 110 rs.102.80 are in real terms since they have not been adjusted for the effect of inflation.
The opportunity cost of capital of a firm or project is generally market determined and is based on expected future returns.It is, therefore, usually expressed in nominal terms and reflects the expected rate of inflation . The opportunity cost of capital of the discount rate is a combination of the real rate( say, k ) and the expected inflation rate. This relationship, long ago recognised in the economic theory, is called the Fisher’s effect . It may be stated as follows.
Nominal discount rate= (1+Real discount rate)×(1+inflation rate)-1
If a firms expect a 10 percent real rate of return an investment project under consideration and the expected inflation rate is 7 percent, the nominal required rate of return on the project would be.
K=(1.10)(1.07)-1=1.177-1=0.177 0r 17.7%
In practice, it is customary to add the real rate and the expected inflation rate to obtain the nominal required rate of return:k=k+