1

Capital Budgeting under Inflation

2

Inflation in Capital BudgetingInflation in Capital Budgeting

• Inflation is the increase in the general level of prices for all goods and services in an economy.

• Inflation is an important fact of economic life and must be considered in capital budgeting.

• REAL VALUES ARE FOUND BY ADJUSTING THE NOMINAL VALUES FOR THE RATE OF INFLATION

3

Inflation in Capital BudgetingInflation in Capital Budgeting

• Nominal Values are the actual amount of money making up Cash Flows.

• Real Valued reflect the purchasing Power of the Cash Flows

• Consider the relationship between interest rates and inflation, often referred to as the Fisher relationship:(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)

INFLATION EFFECTS TWO ASPECTS OF CAPITAL INFLATION EFFECTS TWO ASPECTS OF CAPITAL BUDGETINGBUDGETING

– PROJECTED CASH FLOWS– DISCOUNT RATE

When accounting for inflation in capital budgeting, one must compare real cash flows discounted at real rates

OR

nominal cash flows discounted at nominal rates.

4

5

Is it better to use real or nominal values?Is it better to use real or nominal values?

• Using nominal values is more common.• Market interest rates are nominal values that

already contain a premium for anticipated inflation.

• Income tax obligations are based on nominal values.

• Therefore, it is usually easier to use nominal values.

• However, if a nominal discount rate is used, projected cash flows should reflect anticipated inflation.

6

Sony International has an investment opportunity to produce a new stereo color TV.

The required investment on January 1 of this year is Rs.32 million. The firm will depreciate the investment to zero using the straight-line method. The firm is in the 34% tax bracket.

The price of the product will be Rs.400 per unit. The price will stay constant in real terms.

Labor costs will be Rs.15.30 per hour. They will increase at 2% per year in real terms.

Energy costs will be Rs.5.15 per TV; they will increase 3% per year in real terms.

The inflation rate is 5%. Revenues are received and costs are paid at year-end.

Example of Capital Budgeting under Example of Capital Budgeting under Inflation 7.26Inflation 7.26

7

Example of Capital Budgeting under Example of Capital Budgeting under Inflation 7.26Inflation 7.26

The riskless nominal discount rate is 4%. The real discount rate for costs and revenues is 8%. Calculate the NPV.

  Year 1 Year 2 Year 3 Year 4

Physical Production (units)

100,000 200,000 200,000 150,000

Labor Input (hours)

2,000,000 2,000,000 2,000,000 2,000,000

Energy input, physical units

200,000 200,000 200,000 200,000

8

Example of Capital Budgeting under Example of Capital Budgeting under InflationInflation

The depreciation tax shield is a risk-free nominal cash flow, and is therefore discounted at the nominal riskless rate.

Cost of investment today = Rs.32,000,000Project life = 4 years Annual depreciation expense:

years 4

000,000,32.000,000,8.

RsRs

Depreciation tax shield = Rs.8,000,000 × .34 = Rs.2,720,000

315,873,9Rs.

)04.1(

000,720,2Rs.

)04.1(

000,720,2Rs.

)04.1(

000,720,2Rs.

)04.1(

000,720,2Rs.

DTS

432DTS

PV

PV

9

Example of Capital Budgeting under Example of Capital Budgeting under InflationInflation

• Risky Real Cash Flows

– Price: Rs.400 per unit with zero real price increase

– Labor: Rs.15.30 per hour with 2% real wage increase

– Energy: Rs.5.15 per unit with 3% real energy cost increase

• Year 1 After-tax Real Risky Cash Flows:

After-tax revenues = Rs.400 × 100,000 × (1-.34) = Rs.26,400,000

After-tax labor costs = Rs.15.30 × 2,000,000 × (1-.34) = Rs.20,196,000

After-tax energy costs = Rs.5.15 × 2,00,000 × (1-.34) = Rs.679,800

After-tax net operating CF = Rs.26,400,000 - Rs.20,196,000 - Rs.679,800 =Rs.5,524,200

10

Example of Capital Budgeting under Example of Capital Budgeting under InflationInflation

Rs.5,524,200 Rs.31,499,886 Rs.31,066,882 Rs.17,425,007

-Rs.32,000,000

0 1 2 34

Year One After-tax revenues = Rs.400 × 100,000 × (1-.34) = Rs.26,400,000

Year One After-tax labor costs = Rs.15.30 × 2,000,000 × (1-.34) = Rs.20,196,000

Year One After-tax energy costs = Rs.5.15 × 2,00,000 × (1-.34) = Rs.679,800

Year One After-tax net operating CF =Rs.5,524,200

868,590,69$

)08.1(

007,425,17$

)08.1(

882,066,31$

)08.1(

886,499,31$

)08.1(

200,524,5$

CFsrisky

432CFsrisky

PV

PV

11

Example of Capital Budgeting under Example of Capital Budgeting under InflationInflation

The project NPV can now be computed as the sum of the PV of the cost, the PV of the risky cash flows discounted at the risky rate and the PV of the risk-free cash flows discounted at the risk-free discount rate.

NPV = -Rs.32,000,000 + Rs.69,590,868 + Rs.9,873,315 = Rs.47,464,183