Budgeting Basics and Beyond

20.11. 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.

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.

The two methods are basically equivalent.

Example 21

A company has these projected cash flows estimated in real terms:

	Real Cash Flows (000s)
Period	0	1	2	3
	-100	35	50	30

The nominal cost of capital is 15 percent. Assume that inflation is projected at 10 percent a year. Then the first cash flow for year 1, which is $35,000 in current dollars, will be 35,000 × 1.10 = $38,500 in year 1 dollars. Similarly the cash flow for year 2 will be 50,000 × (1.10)² = $60,500 in year 2 dollars, and so on. By discounting these nominal cash flows at the 15 percent nominal cost of capital, you come up with this net present value:

Period	Cash Flows	Present Value Factor	Present Values
0	-100	1.000	-100
1	38.5	.870	33.50
2	60.5	.756	45.74
3	39.9	.658	26.25
		Net present value =	5.49 or $5,490

Instead of converting the cash ...