Inflation and Capital Budgeting Analysis:
Learning Objectives:
 Does inflation impact capital budgeting
analysis? Explain.
Doesn't inflation have an impact in a
capital budgeting analysis? The answer is qualified yes in that inflation
does have an impact on the numbers that are used in capital budgeting
analysis. But it does not have impact on the results of the analysis if
certain conditions are satisfied. To show what we mean by this statement, we
will use the following data.
Example:
Martin company wants to purchase a new
machine that costs $36,000. The machine would provide annual cost savings of
$20,000, and it would have a threeyear life with no salvage value. For each
of the next three years, the company expects a 10% inflation rate in the
cash flows associated with the new machine. If the company's cost of capital
is 23.2%, should the new machine be purchased?
To answer this question, it is important to
know how the cost of capital was derived. Ordinarily, it is based on the
market rates of return on the company's various sources of financing 
both debt and equity. This market rate of return includes expected
inflation; the higher the expected rate of inflation, the higher the market
rate of return on debt and equity. When the inflationary effect is removed
from the market rate of return, the result is called a real rate of
return. For example if the inflation rate of 10% is removed from the
Martin's cost of capital of 23.2% the real cost of capital is only 12% as
shown below:
Capital Budgeting and Inflation
Reconciliation of the MarketBased and
Real Costs of Capital 


The real cost of capital 
12.0% 

The inflation factor 
10.0 

The combined effect (12% 10% = 1.2%) 
1.2 




The market based cost of capital 
23.2% 


======== 

Solution A: Inflation Not Considered: 
Item 
Year(s) 
Amount of Cash Flows 
12% Factor 
Present Value of Cash Flows 
Initial investment 
Now 
$(36,000) 
1.000 
$(36,000) 
Annual cost savings 
1  3 
20,000 
2.402 
48,040 





Net present value 



$12040* 




========= 
Solution B: Inflation Considered: 
Item 
Year(s) 
Amount of Cash Flows 
Price Index Number** 
Price Adjusted Cash Flows 
23.2%
Factor*** 
Present Value of Cash Flows 
Initial
investment 
Now 
$(36,000) 
1.000 
$(36,000) 
1.000 
$(36,000) 
Annual cost
savings 
1 
20,000 
1.100 
22,000 
0.812 
17,864 

2 
20,000 
1.210 
24,200 
0.659 
15,948 

3 
20,000 
1.331 
26,620 
0.535 
14,242 







Net present
value 





$12,054* 






========= 
*These
amounts are different only because of rounding errors 
**Computation
of the price index numbers, assuming a 10% inflation rate each year:
Year 1, (1.10) = 1.10; Year 2, (1.10)^{2} = 1.21; Year 3, (1.10)^{3}
= 1.331 
***Discount
formulas are computed using the formula 1/(1 + r)^{n}, where r
is the discount factor and n is the number of years. The computations
are 1/1.232 = 0.812 for year 1; 1/(1.232)^{2} = 0.659 for year
2; and 1/(1.232)^{3} = 0.535 for year 3. 
You cannot simply subtract the inflation
rate from the market cost of capital to obtain the real cost of capital. The
computations are bit more complex than that.
When performing a net present value
analysis, one must be consistent. The market based cost of capital reflects
inflation. Therefore, if a market based cost of capital is used to discount
cash flows, then the cash flows should be adjusted upwards to reflect the
effects of inflation in forthcoming periods. Computations of Martin Company
under this approach are given in solution B Above.
On the other hand, there is no need to
adjust the cash flows upward if the "real cost of capital" is used in the
analysis (Since the inflationary effects have been taken out of the discount
rat). Computation of the martin under this approach are given in solution A
above. Note that under solution A and B that the answer will be the same
(within rounding error) regardless of which approach is used, so long as one
is consistent and all of the cash flows associated with the project are
effected in the same way by inflation.
Several points should be noted about
solution B, where the effects of inflation are explicitly taken into
account, First, not that the annual cost savings are adjusted for the
effects of inflation by multiplying each year's cash savings by a price
index number that reflects a 10% inflation rate. (observe from the foot
notes to the solution how the index number is computed for each year.)
Second, note that the net present value obtained in solution B, where
inflation is explicitly taken into account, is the same, within rounding
error, to that obtained in solution A, where the inflation effects are
ignored. This result may seem surprising, but it is logical. The reason is
that we have adjusted both the cash flows and the discount rate so that they
are consistent, and these adjustments cancel each other out across the two
solutions.
Throughout this section of the website
(Capital
Budgeting Decisions) we assume for
simplicity that there is no inflation. In that case, the marketbased and
real costs of capital are the same, and there is no reason to adjust the
cash flow for inflation since there is none. When there is inflation, the
unadjusted cash flows can be used in the analysis if all of the cash flows
are affected identically by inflation and the real cost of capital is used
to discount the cash flows. Otherwise, the cash flows should be adjusted for
inflation and the marketbased cost of capital should be used in the
analysis.
