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Impact of Inflation on capital budgeting decisions:
Inflation can be simply defined as an increase in the average price of goods and services. In general, an inflationary economy distorts capital budgeting decisions. Every attempt should be made to estimate
specific inflation for each element of the project in a detailed manner as feasible.
Inflation could be synchronized or differential. Differential inflation is where costs and revenues changes at differing rates of inflation, while in synchronized inflation, 'costs and revenue rise at the same rate.
Following terminology is considered while evaluating inflation impact in capital budgeting decisions:
(a) Nominal/Money Cash flows = Cash flows at inflated prices.
(b) Real Cash flows = Cash flow at Current Purchasing
Power (without considering inflation)
(c) Nominal/Money DR = Discount rate includes inflation
Premium
(d) Real discount rate = Discount rate does not include
inflation premium
If the required rate of return used as the acceptance criteria includes a premium for anticipated inflation, the estimated cash flows also must reflect inflation. If real cash flows are discounted with a nominal discount rate, there will be a bias towards rejection. Similarly, if nominal cash flows are discounted with a real discount rate there will be bias towards acceptance. Hence usual comparison is nominal with nominal and real with real.
(1 + nominal Discount rate) = (1 + Real discount rate) × (1 + inflation rate)
Real Cash Flows × (1 + inflation rate)n = Nominal Cash flows
Usually, as a practicable measure, cash flows are inflated. However, it seems more logical that profit before interest depreciation & tax shall be inflated first and than effect for interest, depreciation and tax shall be given. The holding is that interest expense; depreciation and tax shield on them are already at inflated values. Hence, if cash flows are inflated; there will be double counting of inflation on depreciation and interest & tax shield thereon.
(a) First, calculate PBDIT at current purchasing power and inflate it.
(b) Deduct interest & depreciation.
(c) Deduct tax. Tax will be calculated on the value obtained as above.
(d) Add back depreciation being non-cash expense. Result will be money cash flow/nominal cash flow.
(e) Discount with nominal/money discount rate.
· If real cash flows are to be ascertained, money cash flows obtained in step (d) as above will be the used for calculation of real cash flows. Alternatively, interest & depreciation will be converted at real values and adjusted accordingly in PBDIT at CPP.