Capital Budgeting and Inflation

The accuracy of capital budgeting decisions depends on the accuracy of the data regarding cash
inflows and outflows. For example, failure to incorporate price-level changes due to inflation in
capital budgeting situations can result in errors in the prediction of cash flows and thus in incorrect
decisions.

Inflation affects capital budgeting analysis. It drives an increase in both revenue and costs,
affecting future cash flows of a project. Inflation is also one of the components of interest rates,
i.e., it is already included in the market cost of capital used as a discount rate.

Typically, the nonfinancial manager has two options in dealing with a capital budgeting situation
with inflation.

1. Restate the cash flows in nominal terms and discount them at a nominal cost of capital
(minimum required rate of return).
2. Restate both the cash flows and cost of capital in constant terms and discount the constant
cash flows at a constant cost of capital.

Delta Company manufactures silicon boards that are used in preparing small, medium and large
size electronic circuits. The company is considering to reduce its cost by automating some of its
manufacturing tasks. This automation requires the installation of a new equipment. The relevant
information for net present value (NPV) analysis of investment in new equipment is given below:

 Cost of equipment: $72,000

 Expected annual cost savings to be provided by new equipment: $40,000
 Useful life of the equipment: 6 years
 Salvage value at the end of 6 years: $0
 Cost of capital: 23.2%
 Expected inflation rate in cash flows associated with the new equipment: 10%

Required:

1. What would be the net present value (NPV) of new equipment if:
(a). the inflation is considered?
(b). the inflation is not considered?
2. Should the new equipment be purchased?

Md. Saiful Islam; Lecturer – Dept. of Finance and Banking-University of Barishal

Solution:
(1) Computation of net present value:

a. If inflation is not considered:

In this problem, we are given the nominal discount rate of 23.2%. In order to compute NPV without
considering inflation, the first step is to compute the real discount rate. It can be computed by using
the following formula:

Real discount rate = (Nominal discount rate – Inflation rate) ÷ (1 + Inflation rate)

= (23.2% – 10%) ÷ (1 + 10%)

= (13.2%) ÷ 1.1

= 12%

The real discount rate is 12% and has been used in the following computations.

Md. Saiful Islam; Lecturer – Dept. of Finance and Banking-University of Barishal

* Value from “present value of an annuity of $1 in arrears table“.

Md. Saiful Islam; Lecturer – Dept. of Finance and Banking-University of Barishal

*(1 + inflation rate)n
**1/(1 + i)n

The net present value computed with and without inflation should be the same. The difference of
$37 ($92477 – $92,440) in NPV figure computed under two approaches is due to rounding error.

(2) Conclusion:

The positive net present value indicates that the project is acceptable. The new equipment should,
therefore, be purchased to automate some manufacturing process.

Inflation-adjusted discount rate

The Fisher equation describes the relationship between the nominal interest rate, real interest rate,
and expected inflation rate. This equation is also used in capital budgeting to calculate the inflation-
adjusted discount rate. It can be written as follows:

1 + rn = (1 + rr) × (1 + i)

Where rn is the nominal discount rate, rr is the real discount rate, and i is the expected inflation
rate.

The nominal and real discount rates can be expressed as follows:

rn = rr + rr×i + i

rr = rn - i

Md. Saiful Islam; Lecturer – Dept. of Finance and Banking-University of Barishal

 1+i

Both nominal and real discount rates can be used in capital budgeting analysis depending on the
method used to account for inflation.

Inflation-adjusted NPV
Two methods can be used to account for inflation when expected cash flows of a project are
discounted to calculate the net present value (NPV).

1. Adjusting cash flows to nominal values. This method implies that all expected cash flows
are adjusted to nominal values, and the nominal discount rate is used to calculate their
present value.
2. Adjusting cash flows to real values. Expected cash flows of a project are adjusted to their
real values and then discounted using the real discount rate.

Both methods bring the same result of project analysis, i.e., the net present value of a project will
be the same regardless of which method is applied.

The relationship between the nominal cash flow value and the real cash flow value can be described
using the following equation:

Nominal Cash Flow = Real Cash Flow × (1 + i) t

Nominal Cash Flow

Real Cash Flow =
(1 + i)t

Where t is the number of periods (e.g., years if the annual inflation rate is applied).

Attention! The inflation rate has a different effect on components of future cash flows. For
example, depreciation expense is not affected at all by inflation unlike the retail prices for products
that directly affect the sales amount.

Example
A company considers undertaking a capital project with an initial cost of $30,000,000 (required to
buy new equipment) and a life span of 3 years. The other parameters of the project are as follows:

 The current sales price is $30 per unit, and expected sales by years are:
o 2,000,000 units in the first year
o 2,500,000 units in the second year
o 2,800,000 units in the third year
 The current variable cost is $21.60 per unit
 The current annual overhead cost is $5,000,000

Md. Saiful Islam; Lecturer – Dept. of Finance and Banking-University of Barishal

  A company applies the straight-line depreciation method, with zero salvage value
 The market cost of capital is 12.50%
 The expected annual inflation rate is 2.5%
 The marginal tax rate is 30%

It is assumed that inflation will affect all the components of future cash flows except the
depreciation expense.

The non-adjusted to inflation cash flows are shown in the table below.

Sales in Year 1 = 2,000,000 × $30 = $60,000,000

Sales in Year 2 = 2,500,000 × $30 = $75,000,000

Sales in Year 3 = 2,800,000 × $30 = $84,000,000

Total variable costs in Year 1 = 2,000,000 × $21.60 = $43,200,000

Total variable costs in Year 2 = 2,500,000 × $21.60 = $54,000,000

Total variable costs in Year 3 = 2,800,000 × $21.60 = $60,480,000

When the straight-line depreciation method is applied, the depreciation expense is the same in each
year and amounts to $10,000,000.

Now we can calculate earnings before tax in each year by deducting total variable costs, overhead
costs, and depreciation expense from the sales figures.

Earnings before tax in Year 1 = $60,000,000 - $43,200,000 - $5,000,000 - $10,000,000 =

$1,800,000

Md. Saiful Islam; Lecturer – Dept. of Finance and Banking-University of Barishal

Earnings before tax in Year 2 = $75,000,000 - $54,000,000 - $5,000,000 - $10,000,000 =
$6,000,000

Earnings before tax in Year 3 = $84,000,000 - $60,480,000 - $5,000,000 - $10,000,000 =

$8,520,000

The tax expense in each year is as follows:

Tax expense in Year 1 = $1,800,000 × 30% = $540,000

Tax expense in Year 2 = $6,000,000 × 30% = $1,800,000

Tax expense in Year 3 = $8,520,000 × 30% = $2,556,000

The net profit is calculated by deducting the tax expense from earnings before taxes.

Net profit in Year 1 = $1,800,000 - $540,000 = $1,260,000

Net profit in Year 2 = $6,000,000 - $1,800,000 = $4,200,000

Net profit in Year 3 = $8,520,000 - $2,556,000 = $5,964,000

The net cash flow is the sum of depreciation expense and net profit.

Net cash flow in Year 1 = $1,260,000 + $10,000,000 = $11,260,000

Net cash flow in Year 2 = $4,200,000 + $10,000,000 = $14,200,000

Net cash flow in Year 3 = $5,964,000 + $10,000,000 = $15,964,000

We should adjust cash flows to the inflation rate to calculate the inflation-adjusted NPV of a
project. Cash flows adjusted to their nominal values are presented in the table below.

Md. Saiful Islam; Lecturer – Dept. of Finance and Banking-University of Barishal

The real values of sales, total variable costs, and overhead should be adjusted to their nominal
values at the end of each designated year.

Sales in Year 1 = $60,000,000×(1+0.025)1 = $61,500,000.00

Sales in Year 2 = $75,000,000×(1+0.025)2 = $78,796,875.00

Sales in Year 3 = $84,000,000×(1+0.025)3 = $90,458,812.50

Total variable costs and overhead costs are adjusted to nominal values in the same manner.

Depreciation expense is not affected by inflation; thus, its value is already nominal.

Now we can calculate the inflation-adjusted NPV of a project using the market cost of capital as
the nominal discount rate because it already reflects the inflation.

$11,466,500 $14,767,000 $16,960,810.06

NPV = -$30,000,000 + + + = $3,772,316.53
(1+0.125)1 (1+0.125)2 (1+0.125)3

Let’s adjust all cash flows to their real value to prove that both methods bring the same NPV. Cash
flows adjusted to their real values are given in the table below.

Md. Saiful Islam; Lecturer – Dept. of Finance and Banking-University of Barishal

Since only depreciation expenses are given as nominal values, they should be adjusted to real
values as follows:

$10,000,000
Depreciation expense in Year 1 = = $9,756,097.56
(1+0.025)1
$10,000,000
Depreciation expense in Year 2 = = $9,518,143.96
(1+0.025)2
$10,000,000
Depreciation expense in Year 3 = = $9,285,994.11
(1+0.025)3

We should also adjust the market cost of capital to the real value.

12.50%-2.50%
Real discount rate = = 9.76%
1+0.025
$11,186,829.27 $14,055,443.19 $15,749,798.23
NPV = -$30,000,000 + 1
+ 2
+ = $3,772,316.53
(1+0.0976) (1+0.0976) (1+0.0976)3

As we have seen, both methods give the same net present value of a project. Thus, each method
can be used in capital budgeting analysis provided cash flows and the discount rate are properly
adjusted to the inflation rate.

The bottom line

Now we can claim with confidence that inflation affects capital budgeting analysis. It affects the
values of future cash flows and the discount rate. To remove the impact of inflation, future cash
flows and the discount rate should both be adjusted to either their real values or to nominal values.
However, both ways lead to the same result, i.e., to the same figure of inflation-adjusted NPV. In
other words, inflation has an effect on figures used in capital budgeting analysis, but it does not
affect the result of analysis.

Md. Saiful Islam; Lecturer – Dept. of Finance and Banking-University of Barishal

Md. Saiful Islam; Lecturer – Dept. of Finance and Banking-University of Barishal