Chapter 10 -- Inflation and Capital Investment Analysis Why is inflation important? Expected inflation is in the discount rate (WACC) that is used to calculate the net present value of a project, so it must also be included in the cash flow projections.

Inflation and Capital Investment Analysis Adjusting current dollars to constant dollars Constant dollars= Current price / (PIt/ PIb)

Inflation and Capital Investment Analysis Real rates of return Real rates do not include inflation. We cannot observe real rates, but we can “estimate” what real rates might have been in prior periods. We observe nominal, market or quoted rates. These rates do include expected inflation.

Inflation and Capital Investment Analysis – Timing of the impact Income and consequently cash flow may or may not be affected immediately by inflation. Inflation may increase the revenue stream before, during or after the cost stream. The competitiveness of the industry has an impact on how quickly the impact of inflation is reflected in income and cash flow. Inventory can cause a delay in the pass through of cost increases. The practice of annual raises may also delay the the increase.

Inflation and Capital Investment Analysis – Size of the Impact Inflation may not impact the revenue stream in the same proportion as it does the cost stream The cost stream may be somewhat independent of the supply and demand characteristics in the finished product market. Examples – Tires, Personal Computers, Cereal The competitiveness of the industry also has an impact on how much of the cost streams inflation or deflation is reflected in income and cash flow.

Inflation and Capital Investment Analysis While inflation may or may not change income… an increase in the cost stream may cause an increase in the investment in working capital and a decrease in cash flows an increase in price will cause and increase in working capital (accounts receivable).

Inflation and Capital Investment Analysis Because depreciation and some inventory methods are based on historical cost rather than replacement cost… taxable income may increase (while being used for additional working capital) cash payments for taxes may increase therefore lowering cash flows

Inflation and Capital Investment Analysis By locking in interest rates on the debt used to finance a portion of the project, inflation may increase the wealth created by the project. Empirical studies have shown that during recent periods of high inflation the value of common stock, on average, has declined with increases in inflation. The equivalent annuity method, adjusted for inflation, can be used for choosing between mutually exclusive projects in the same way that it was used without inflation.