Fundamentals of Financial Management, Third Edition

6.2 CAPITAL BUDGETING UNDER INFLATIONARY CONDITIONS

Inflation is a common phenomenon. It has a direct impact on:

1. The cost structure in form of rising prices of input;
2. The revenue in form of higher prices of the output;
3. The required rate of return on account of higher cost of capital.

As a result, the treatment of the inflation factor is of much significance in the process of capital budgeting. However, if the same rate of inflation is found in case of all the three variables, the changes will cancel out one another and the NPV will remain unchanged. On the contrary, if these three variables are subjected to different rates of inflation, the impact on the NPV will definitely be visible.

When estimates of cash flow are inclusive of inflation, ...