Capital Budgeting under Inflation

Inflation 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

Inflation 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 BUDGETING

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.

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.

Example of Capital Budgeting under Inflation 7.26

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 straightline 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.
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Example of Capital Budgeting under Inflation 7.26

Year 1 Physical Production (units) Labor Input (hours) Energy input, physical units 100,000 Year 2 200,000 Year 3 200,000 Year 4 150,000

2,000,000 200,000

2,000,000 200,000

2,000,000 200,000

2,000,000 200,000

The riskless nominal discount rate is 4%. The real discount rate for costs and revenues is 8%. Calculate the NPV.
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Example of Capital Budgeting under Inflation

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.32,000,000 Project life = 4 years Annual depreciation expense: Rs.32,000,000 Rs.8,000,000 4 years Depreciation tax shield = Rs.8,000,000 .34 = Rs.2,720,000 PV DTS PV DTS

Rs.720,000 Rs.720,000 Rs.720,000 Rs.720,000 2, 2, 2, 2, + + + (1.04) (1.04)2 (1.04)3 (1.04)4 Rs.873,315 9,

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Example of Capital Budgeting under Inflation

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 9 After-tax net operating CF = Rs.26,400,000 - Rs.20,196,000 -

Example of Capital Budgeting under Inflation

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

Rs.5,524,200 Rs.17,425,007

Rs.31,499,886

Rs.31,066,882

0
-Rs.32,000,000

$5,524,200 $31,499,886 $31,066,882 $17,425,007 + + + 2 3 (1.08) (1.08) (1.08) (1.08)4 PVrisky CFs $69,590,868 PVrisky CFs

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Example of Capital Budgeting under Inflation

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

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