Inflation and Capital Budgeting

  • Inflation has ramifications for the realized value of a capital project.
  • When evaluating capital projects, companies can evaluate capital projects in nominal or real (i.e. inflation adjusted) terms.
  • Real cash flows are based on purchasing power at the time the decision to invest would is made.
    • Under a real cash flow approach, the discount rate would remove the expected inflation rate, as the cash flows will already reflect the effects of inflation.
  • Commonly, capital projects are analyzed in nominal terms, so the discount rate applied is inclusive of expected inflation; however actual inflation may veer from expectations and inflation may impact the different project variables in different ways.
  • There are several aspects of inflation that an analyst must consider when evaluating a capital project:
    • Inflation and the Depreciation Tax Shied: if inflation is higher than expected at the time of the investment decision, then the value of the depreciation tax shield is lowered and true net present value of the project is lowered.
    • Inflation and Debt Payments: the discount rate may be based on a company’s cost of debt, if debt is used to finance the capital project.  When inflation is lower than expected, this increases the firm’s debt costs and lowers the net present value of the project.
    • Inflation, Revenues, and Expenses: the revenues and expenses associated with a capital project will not be equally affected by inflation.  When a firm is not able to pass the costs of inflation to product inputs on to customers in the form of higher prices, the net present value of the project will be lower.
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