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CHAPTER 6

CHAPTER 6. AN INTEGRATED APPROACH TO FINANCIAL ANALYSIS. TABLE OF CONTENTS. INTRODUCTION NOMINAL, REAL PRICES AND INFLATION MARKET AND REAL EXCHANGE RATES INFLATION AND NOMINAL INTEREST RATE IMPACTS OF INFLATION 5.1 DIRECT IMPACTS 5.2 TAX IMPACTS. INTRODUCTION.

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CHAPTER 6

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  1. CHAPTER 6 AN INTEGRATED APPROACH TO FINANCIAL ANALYSIS

  2. TABLE OF CONTENTS • INTRODUCTION • NOMINAL, REAL PRICES AND INFLATION • MARKET AND REAL EXCHANGE RATES • INFLATION AND NOMINAL INTEREST RATE • IMPACTS OF INFLATION • 5.1 DIRECT IMPACTS • 5.2 TAX IMPACTS

  3. INTRODUCTION • Projects which are feasible in the absence of inflation could turn out to be unfeasible with inflation. • Countries have inflation at varying levels. • Inflation effects the outcome of the project through direct impacts (on investments, A/R, A/P, cash held, interest expenses) and tax impacts (interest expenses deductions, depreciation expenses and inventories and cost of goods sold). • In this chapter we will see how inflation effects the outcome of a project and how we could integrate it into our model in order to capture its effects.

  4. 2. NOMINAL, REAL PRICES AND INFLATIONS 1. Nominal Prices (Current prices) P1t,P2t, P3t……….. Pnt 2.Price Level PLt = in (Pit Wi) Where: i = Individual good or service included in the market basket Pit= Price of the good or service i at a point in time Wi = Weight given to the price of a particular good or service (i); where wi = 1 Note: it is generally useful to express the price level of a basket of goods and services at a specific point in time in terms of a price index (P ) PtI = PtL/PBL Where PtL = Price level in period (t) PBL = Price level for the base period (B)

  5. 2. NOMINAL, REAL PRICES AND INFLATIONS (Cont’d) 3. Changes in Price Level (Inflation) • Measured in terms of a price index: gP = ((PIt - PIt-1 )/(PIt-1 )) * 100 4. Real Prices PtJR = PtJ / PtI Where P = nominal price of good or service as of a point in time P = Price level index at time period (t) 5. Changes in Real Prices Change in PtJR = (PtJR– Pt-1JR) / Pt-1JR Where PtJRdenotes the real price of goods (j) as of a specific period

  6. Example 1: Nominal Prices and Changes in Price level Assume Year 1 is base year Goods 1 2 3 Weights 0.2 0.5 0.3 Nominal Prices Year 1: P11 =30P21=100 P31=50 P L1 =0.2(30)+0.5(100)+0.3 (50) P L1 =71 P LB= 71 Price Index P I1 =1.00 Nominal Prices Year 2: P12 =40P22=110 P32=40 PL2 =0.2(40)+0.5(110)+0.3(40)= P L2 =75 P LB= 71 Price Index P I2 =1.056

  7. Example 1:Nominal Prices and Changes in Price Level (cont’d) Assume Year 1 is base year Goods 1 2 3 Weights 0.2 0.5 0.3 Nominal Prices Year 3: P13 =35P23=108 P33=60 P L3 =0.2(35)+0.5(108)+0.3 (60) P L3 =79 Price Index P I3 =1.113 gP I2 = ((P I2 - P I1 )/(P I1 )) * 100=((1.056-1.00)/1.00))*100=5.63% gP I3 = ((P I3 - P I2 )/(P I2 )) * 100=((1.113-1.056)/1.056)*100=5.33%

  8. EXAMPLE 2: Real Prices and Changes in Real Prices Goods 1 2 3 Weights 0.2 0.5 0.3 Nominal Prices Year 1: P11 =30P21=100 P31=50 Price Index P I1 =1 Real Prices Year 1: P1R1=30/1 P2R1=100/1 P3R1=50/1 P1R1=30 P2R1=100 P3R1=50 ---------------------------------------------------------------------------------------------------------------------------------------- Nominal Prices Year 2: P12 =40P22=110 P32=40 Price Index P I2 =1.056 Real Prices Year 2:P1R2=40/1.056 P2R2=110/1.056 P3R2=40/1.056 P1R2=37.87 P2R2=104.13 P3R2=37.87

  9. EXAMPLE 2: Real Prices and Changes in Real Prices (Cont’d) Goods 1 2 3 Weights 0.2 0.5 0.3 Nominal Prices Year 3:P13 =35P23=108 P33=60 Price Index P I3 =1.113 Real Prices Year 3: P1R3=35/1.113 P2R3=108/1.113 P3R3=60/1.113 P1R3=31.46 P2R3=97.06 P3R3=53.92 Changes in Real Prices Year 2 Change in PiR2= PiR2 -PiR1 / (PiR1) = ((37.80-30)/30)=0.26 ( (104.13-100)/100)=0.04 ((37.80-50)/50) 0.26 0.04 -0.24 Changes in Real Prices in Year 3 Change in P1R3= P1R3 -P1R2 / (P1R2 )= ((31.46-37.87)/37.87) ((97.06-104.13)/104.13) ((53.92-37.87)/37.87) =- 0.17 =- 0.07 =0.42

  10. 2. NOMINAL, REAL PRICES AND INFLATION (Cont’d) 6. Inflation Adjusted Values  Pjt+1= Pjt ( 1 + gPtjR ) (1 + gPIe) Where:  Pjt+1 = denotes the estimated nominal price of good (j) in year t+1; Pjt = denotes the nominal price of good (j) in year t ; gPtjR= denotes the estimated growth in real price of good (j); PIe = denotes the assumed growth in price level index from year t to year t+1 7. Constant Prices Fixed set of prices at given year t0 Ptt+n = Pito ; Pkt+n =Pkto Note: It simplifies the construction of Cash flow statements but ignores financial and economic information that can affect the future performance of the project.

  11. 3.MARKET AND REAL EXCHANGE RATES • The market exchange rate is the current price of foreign exchange. The market rate between the domestic currency and the foreign currency can be expressed at a point in time (t) as: E = (#D/F)t • If the price index for the domestic currency’s economy is ID at the time t, and the price index for the foreign currency’s country is IF , then the real exchange rate (ER) at that point in time can be expressed as: EtR = (#D/F)t * (ItF / ItD) EtR = EtM * (ItF / ItD) --------- EtM = EtR * (ItD / ItF)

  12. 4.INFLATION AND NOMINAL INTEREST RATES • Nominal Interest Rate = (i) • Real Interest Rate = (r) • Risk Premium = R • Expected Growth (inflation) in Prices = gPe • Given the factors above, nominal interest rate is • calculated as: i = r + R + (1 + R + r) gPe

  13. Example • By using following information Inflation rate( gPe ) = 20% Risk Premium ( R ) = 0 Real Interest Rate (r) = 0.05 i = r + R + (1 + R + r) gPe i = 0.05 + 0 + (1 + 0 + 0.05)* 0.20 i = 0.26

  14. 5. IMPACTS OF INFLATION 5.1 Direct Impacts of Inflation • (i) Impact on Financial Investment a.Costs could increase due to increases in price levels. This is normal and the model captures this. It is part of the financing plan. b.Over-run costs are unplanned increases in costs which could be due to delay in finishing the project or unexpected increase in the cost of inputs. c.Inflation will effect the nominal value of the investment financing but it will not effect the cash flow in real values.

  15. Table 6-1Project XYZ Financing Period 0 1 Inflation = 0% 1. Price Index 1.00 1.00 2. Investment Outlays 500 500 Inflation = 25% 3. Price Index 1.00 1.25 4. Investment Outlays 500 625 5. Impact on Financing 0 125 6. Real Inv. Outlays (4/3) 500 500 *Inflation will not effect the real value of investment expenditure

  16. Impact on Interest and PrincipalPayments • i = r + R + (1+R+r) gPe • At r = 5% and gPe=20%  i = 26% • Comparing two cases Case 1: $1000 loan, @ 5% Interest, No inflation Case 2: $1000 loan, @ 5% Interest (26% in nominal rate) • In real values for both cases there is no difference in the amount of payment for interest and principal. • In real values Case 2 (inflation) pays higher installments (interest payments) and a lower principal at the end of the project compared to Case 1. Case 2 can fall into the liquidity trap during the project years, while Case 1 may not be able to pay the principal in the final year.

  17. Table 6-2Inflation and Its Effect on Interest and Principal Payments Period Price Index 1. $1000 Loan @5% Interest & No Inflation Loan Interest Loan Payment Cash Flow in Year 0 Prices Net Present Value (Equilibrium Situation) 0 1.0 +1000 +1000 0 1 1.0 -50 -50 2 1.0 -50 -50 3 1.0 -50 -50 4 1.0 -50 -1000 -1050 Price Index 2. $1000 Loan @ 26.0% Interest & 20% Inflation Loan Interest Loan Payment Cash Flow in Current Prices Cash Flow in year 0 Prices Net Present Value (Dis-Equilibrium Situation) 3. Undiscounted Change in Cash Flow =Case 1 - Case 2 in Year 0 Prices 1.0 +1000 +1000 +1000 0 0 1.2 -260 -260 -216.67 +166.67 1.44 -260 -260 -180.56 +130.56 1.728 -260 -260 -150.46 +100.46 2.074 -260 -1000 -1260 -607.64 -442.36 Real Cash Flow Case 1 (No inflation) +1000 -50.00 -50.00 -50.00 -1050.00 Case 2 (Inflation) +1000 -216.67 -180.50 -150.46 -607.64

  18. (iii) Impact on Desired Cash Balances • Inflation results in a loss in the purchasing power of the cash hold. • When there is an inflation, sales receipts, expenditures increase in nominal prices even if the amount of goods sold does not change. • Increase in inflation increases the desired cash balances both in nominal and real values thus the cost of the project increases. • Inflation has an adverse effect on the outcome of the project through increasing the amount of desired cash holdings.

  19. 0 2000 200 -200 1 2000 200 0 2 2000 200 0 3 2000 200 0 4 0 - +200 Inflation and Desired Cash Balances Case A: (With Zero Inflation) Assumptions • Zero Inflation • Desired cash = 10% of Annual Sales • Real rate of discount = 5% Year Sales Desired Cash Cash Flow Impact Real PV of Holding Cash = -200 + 200/(1+.05)4 = -35.46

  20. 0 1 2000 200 -200 -200 1 1.2 2400 240 -40 -33 2 1.44 2880 288 -48 -33 3 1.728 3456 345.6 -57.6 -33 4 2.074 0 0 +346 167 Inflation and Desired Cash Balances (Cont’d) Case B: (With 20% inflation) Assumptions • 20% Inflation • Desired cash = 10% of Sales • Real rate of discount = 5% Year Price Index Sales Desired Cash Cash Flow Impact Real Cash Flow PV@ 5% = -153.66 With inflation rate of 20% the cost of cash balances have increased 4.33 times

  21. (iv) Impact on Accounts Receivable • Increase in inflation will increase the sales and accounts receivable in nominal prices. • Through inflation accounts receivables will increase in real terms as well. This will have a negative effect on the net cash flow of the project. • Inflation has a negative effect on the outcome of the project through increasing the amount of accounts receivables in real terms.

  22. (iv) Impact on Accounts Receivable (Cont’d) • Likewise inflation has a positive effect on the project through accounts payable, as the payment in real values decreases. • When inflation rises, buyers will try to postpone payments (increase accounts payable), while the sellers will try to shorten the period of payments of their customers (reduce the accounts receivables).

  23. 0 2000 1000 -1000 1000 1 2000 1000 0 2000 2 2000 1000 0 2000 3 2000 1000 0 2000 4 0 0 +1000 +1000 Impact of Inflation on Accounts Receivable and Accounts Payable Case A: (With Zero Inflation) Assumptions • Zero Inflation • Acts Receivable = 50% of Sales Year Sales Acts Receivable Change /AR Receipts

  24. 0 1 2000 1000 -1000 1000 1000 1000 0 1 1.2 2400 1200 -200 2200 1833 2000 -167 2 1.44 2880 1440 -240 2640 1833 2000 -167 3 1.728 3456 1728 -288 3168 1833 2000 -167 4 2.074 0 0 +1728 1728 833 +1000 -167 Impact of Inflation on Accounts Receivable and Accounts Payable Case B: (With 20% inflation) Assumptions • 20% Inflation • Acts Receivable = 50% of Sales Year Price Index Sales Acts Receivable Change /AR Receipts A. Real Receipts if 20% inflation B. Real Receipts if zero inflation Difference (A-B)

  25. 5.2 Tax Impacts of Inflation • Impact through Tax Deductıon of Interest Payment • Interest payments are deducted from the taxable income, while the principal payment is not. • As you would recall, inflation increases the interest payments in real values during the project life, while reducing the amount of principal to be paid in the final year (5.1(ii)). • Increase in inflation has a positive effect on the outcome of the project through increasing the annual interest payment and reducing the taxable income and thus reducing the tax to be paid to the government.

  26. Year Interest Expense A: If tc = 40%, Tax savings 0 1 50 20 2 50 20 3 50 20 4 50 20 Year Nominal Interest Expense Real Interest Expense B: If tc = 40%, Tax Savings Increased Tax Shelter (B-A) 0 1 260 216.67 86.67 66.67 2 260 180.56 72.22 52.22 3 260 150.46 60.19 40.19 4 260 125.39 50.15 30.15 Tax Impacts of Inflation Tax Deduction of Interest Expense Tax shelter of interest expense because it is a deduction from taxable income Case A: If 5% interest rate, $1000 loan, and zero inflation then Case B: If 20% inflation, 26.0% interest, $1000 loan then:

  27. (ii) Impact through Depreciation Expense and Taxes • Depreciation allowances are deductible from the taxable income. • When inflation rises, the depreciation allowance in real values decreases and this increases the taxable income. Thus tax payment to the government increases. • Increase in inflation has a negative effect on the outcome of the project through reducing the depreciation allowance.

  28. Year Depreciation Tax Savings if tc = .40 A: If zero inflation, real value of tax savings Price Index if 20% inflation B: If 20% inflation then real value of savings Real difference in tax savings (A-B) 0 1 1 250 100 100 1.20 83.33 16.67 2 250 100 100 1.44 69.44 30.56 3 250 100 100 1.73 57.80 42.20 4 250 100 100 2.07 48.31 51.69 Inflation Depreciation Expense and Taxes Investment of $1000 in year zero, depreciated over 4 years,depreciation expense is deductible from taxable income

  29. (iii) Impact through Inventories and Goods Sold • FIFO (First In First Out): Price of old inventory (input) is used to calculate the cost of goods sold. • LIFO (Last In First Out): Price of last input is used. • An increases in inflation increases the amount of tax to be paid through both approaches (FIFO and LIFO). • In FIFO, the additional tax to be paid is spread out through the project life. • In LIFO, the additional tax to be paid accumulates to the final year of the project. This is very risky.

  30. Year A. Sales of Output B. Purchases of Input C. COGS D. Measured Profits (A-C) E. Taxes Paid if tc = .40 If 20% Inflation Price index a. Sales b. Purchases of Input c. COGS d. Measured Profits e. Nominal Taxes Paid if tc = .40 f. If Real Taxes Paid Difference f-E 0 0 100 1.00 0 100 1 300 100 100 200 80 1.2 360 120 100 260 104 86.67 6.67 2 300 100 100 200 80 1.44 432 144 120 312 124.8 86.67 6.67 3 300 0 100 200 80 1.728 518.4 0 144 374.4 149.76 86.67 6.67 Inflation, Inventories and Cost of Good Sold Two ways of accounting for cost of goods sold: (1) FIFO (2) LIFO 1. FIFO: If Zero Inflation Note: Additional tax liability is distributed evenly.

  31. Year A. Sales of Output B. Purchases of Input C. COGS D. Measured Profits (A-C) E. Taxes Paid if tc = .40 If 20% Inflation (Price index) a. Sales b. Purchases of Input c. COGS d. Measured Profits e. Nominal Taxes Paid if tc = .40 f. If Real Taxes Paid Difference f-E 0 0 100 1.00 0 100 1 300 100 100 200 80 1.2 360 120 120 240 96 80 0 2 300 100 100 200 80 1.44 432 144 144 288 115.2 80 0 3 300 0 100 200 80 1.728 518.4 0 100 418.4 167.36 96.85 16.85 Inflation, Inventories and Cost of Good Sold 2. LIFO: If Zero Inflation Note: Additional tax liability accumulated in the final year.

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