Inflation and capital budgeting

Inflation and capital budgeting

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

^v   Nominal values are the actual amount of money making up cash flows

^v   real values reflect the purchasing power of the cash flows

^v   real values are found by adjusting the nominal values for the rate of inflation

Inflation effects two aspects of capital budgeting

o  projected cash flows

o  discount rate

if projected cash flows are in nominal terms (with inflation considered) the discount rate used should be a nominal rate

Is it better to use real or nominal values?

^v   Using nominal values is more common.

^v   Market interest rates are nominal values that already contain a premium for anticipated inflation.

^v   Income tax obligations are based on nominal values.

^v   Therefore, it is usually easier to use nominal values.

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

Risk And Capital Budgeting

Risk pertains to the possibility that the projected cash flows will be less than estimated adjusting the discount rate

Discount rate components include:

–   time preference

–   inflation expectations

–   risk premium

Risk premium is the cost of risk bearing

•         increasing the discount rate adds a cost for taking risk by requiring a higher rate of return for risk bearing.

Certainty equivalent approach

•         adjusts the cash flows to a level with a higher ―certainty‖ that they will be received.

 •   conceptually similar to a risk premium.

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