Friday, June 4, 2010


Investment Decisions under Inflation

A common problem, which complicates the practical investment decision-making, is inflation. The rule of the game is, as we shall emphasize in the flowing discussions, to be consistent in treating inflation in the cash flows and the discount rate.

Inflation is a fact of life all over the world. A double-digit rate of inflation is a common feature in developing countries. Because the cash flows of an investment project occur over a long period of time, a firm should usually be concerned about impact of inflation on the project’s profitability. The capital budgeting results will be biased if the impact of inflation is not correctly factored in the analysis.

Because executives do recognize that inflation exists but they do not consider it necessary to incorporate inflation in the analysis of capital investment. They generally estimate as cash flows assuming unit costs and selling price prevailing in year zero to remain uncharged. They argue that if there is inflation, prices can be increased to cover increasing costs; therefore, the impact on then projects profitability would be the same if they assume rate of inflation to be zero. This line of argument, although seems to be convincing, is fallacious for two reasons.
  1. The discount rate used for discounting cash flows is generally expressed in nominal terms. It would be inappropriate and inconsistent to use a nominal rate to discount constant cash flows.
  2. Selling prices and costs show different decrease of responsiveness to inflation. In the case of certain products, prices may be controlled by the government, or by restrictive competition, or there may exist a long term contact to supply goods or services at a fixed price.

The drugs and pharmaceutical industry is an example of controlled, slow-rising prices in spite of the rising of the general price level. Costs are usually sensitive to inflation. However, some costs price rise faster than other. For example, wages may increase at rate higher than, say, fuel and power, or even raw material. There are yet examples of certain items, which are not affected by inflation. The depreciation tax shield remains unaffected by inflation since depreciation is allowed on the book value of an asset; irrespective of its replacement are market prices, for tax purposes.

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