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INFLATION AND CAPITAL BUDGETING

INFLATION AND CAPITAL BUDGETING. INFLATION IS THE INCREASE IN THE GENERAL LEVEL OF PRICES FOR ALL GOODS AND SERVICES IN AN ECONOMY. NOMINAL VS. REAL. NOMINAL VALUES ARE THE ACTUAL AMOUNT OF MONEY MAKING UP CASH FLOWS REAL VALUES REFLECT THE PURCHASING POWER OF THE CASH FLOWS

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INFLATION AND CAPITAL BUDGETING

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  1. INFLATION AND CAPITAL BUDGETING • INFLATION IS THE INCREASE IN THE GENERAL LEVEL OF PRICES FOR ALL GOODS AND SERVICES IN AN ECONOMY

  2. NOMINAL VS. REAL • NOMINAL VALUES ARE THE ACTUAL AMOUNT OF MONEY MAKING UP CASH FLOWS • REAL VALUES REFLECT THE PURCHASING POWER OF THE CASH FLOWS • REAL VALUES ARE FOUND BY ADJUSTING THE NOMINAL VALUES FOR THE RATE OF INFLATION

  3. INFLATION EFFECTS TWO ASPECTS OF CAPITAL BUDGETING • PROJECTED CASH FLOWS • DISCOUNT RATE

  4. IF PROJECTED CASH FLOWS ARE IN REAL TERMS (WITHOUT INFLATION CONSIDERED) THE DISCOUNT RATE USED SHOULD BE A REAL RATE. • IF PROJECTED CASH FLOWS ARE IN NOMINAL TERMS (WITH INFLATION CONSIDERED) THE DISCOUNT RATE USED SHOULD BE A NOMINAL RATE.

  5. BOTH THE PAYMENT SERIES AND THE DISCOUNT RATE MUST BE SPECIFIED EITHER IN NOMINAL VALUES OR IN REAL VALUES, BUT NOT IN BOTH VALUES CONCURRENTLY.

  6. 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.

  7. RISK AND CAPITAL BUDGETING • RISK PERTAINS TO THE POSSIBILITY THAT THE PROJECTED CASH FLOWS WILL BE LESS THAN ESTIMATED.

  8. METHODS OF ACCOUNTING FOR RISK IN CAPITAL BUDGETING ARE: • ADJUSTING THE DISCOUNT RATE TO REFLECT A RISK PREMIUM. • CONVERTING THE PAYMENT SERIES TO CERTAINTY EQUIVALENTS. • PROBABILITY ANALYSIS.

  9. ADJUSTING THE DISCOUNT RATE • DISCOUNT RATE COMPONENTS INCLUDE: • TIME PREFERENCE • INFLATION EXPECTATIONS • RISK PREMIUM

  10. THE 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.

  11. 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.

  12. PROBABILITY ANALYSIS • DETERMINES AN EXPECTED CASH FLOW AND ITS ASSOCIATED PROBABILITY OF OCCURRING. • DERIVE A PROBABILITY WEIGHTED EXPECTED RETURN. • USE THE WEIGHTED CASH FLOW ESTIMATE

  13. COMPARING INVESTMENTS WITH DIFFERENT ECONOMIC LIVES • WHEN COMPARING INVESTMENTS WITH DIFFERENT ECONOMIC LIVES THE NET PRESENT VALUES ARE NOT DIRECTLY COMPARABLE. • ONE METHOD TO ADJUST FOR UNEQUAL PLANNING HORIZONS IS TO USE THE ANNUITY EQUIVALENT.

  14. ANNUITY EQUIVALENT • THE ANNUITY EQUIVALENT IS THE PAYMENT THAT WOULD BE NECESSARY TO ACHIEVE THE PRESENT VALUE AT THE DISCOUNT RATE AND TIME PERIOD OF THE INVESTMENT.

  15. THE ANNUITY EQUIVALENT IS FOUND BY TAKING THE NPV AS CALCULATED FOR EACH INVESTMENT ALTERNATIVE, SETTING THE NPV AS THE PRESENT VALUE USING THE SAME DISCOUNT RATE AND TIME HORIZON, AND SOLVING FOR THE PAYMENT. • THE PAYMENT REPRESENTS THE ANNUITY EQUIVALENT

  16. ANNUITY EQUIVALENT

  17. INVESTMENT “A” • CF0 = -100,000 • CF1 = 20,000 • F1 = 7 • I = 8% • NPV = 4,127

  18. INVESTMENT “B” • CF0 = -100,000 • CF1 = 26,000 • F1 = 5 • I = 8% • NPV = 3,810

  19. CALCULATION OF THE ANNUITY EQUIVALENT

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