Appendix Capital Budgeting and Inflation

The Vector example (Exhibits 22-2 to 22-6) does not include adjustments for inflation in the relevant revenues and costs. Inflation is the decline in the general purchasing power of the monetary unit, such as dollars. An inflation rate of 10% per year means that an item bought for $100 at the beginning of the year will cost $110 at the end of the year.

Why is it important to account for inflation in capital budgeting? Because declines in the general purchasing power of the monetary unit will inflate future cash flows above what they would have been in the absence of inflation. These inflated cash flows will cause the project to look better than it really is unless the analyst recognizes that the inflated cash flows are measured in dollars that have less purchasing power than the dollars that were initially invested. When analyzing inflation, distinguish real rate of return from nominal rate of return:

Real rate of return is the rate of return demanded to cover investment risk if there is no inflation. The real rate is made up of two elements: (1) a risk-free element (the pure rate of return on risk-free long-term government bonds when there is no expected inflation) and (2) a business-risk element (the risk premium demanded for bearing risk).

Nominal rate of return is the rate of return demanded to cover investment risk and the decline in general purchasing power of the monetary unit as a result of expected inflation. The nominal rate is made up of three elements: (1) a risk-free element when there is no expected inflation, (2) a business-risk element, and (3) an inflation element. Items 1 and 2 make up the real rate of return to cover investment risk. The inflation element is the premium above the real rate. The rates of return earned in the financial markets are nominal rates because investors want to be compensated both for the investment risks they take and for the expected decline in the general purchasing power, as a result of inflation, of the money they get back.

Assume that the real rate of return for investments in high-risk cellular data-transmission equipment at Network Communications is 20% per year and that the expected inflation rate is 10% per year. Nominal rate of return is as follows:

Nominal rate of return is related to the real rate of return and the inflation rate:

Note the nominal rate, 0.32, is slightly higher than 0.30, the real rate (0.20) plus the inflation rate (0.10). That’s because the nominal rate recognizes that inflation of 10% also decreases the purchasing power of the real rate of return of 20% earned during the year. The combination component represents the additional compensation investors seek for the decrease in the purchasing power of the real return earned during the year because of inflation.^*

Net Present Value Method and Inflation

When incorporating inflation into the NPV method, the key is internal consistency. There are two internally consistent approaches:

1. NOMINAL APPROACH—predicts cash inflows and outflows in nominal monetary units and uses a nominal rate as the required rate of return
2. REAL APPROACH—predicts cash inflows and outflows in real monetary units and uses a real rate as the required rate of return

We will limit our discussion to the simpler nominal approach. Consider an investment that is expected to generate sales of 100 units and a net cash inflow of $1,000 ($10 per unit) each year for 2 years absent inflation. Assume cash flows occur at the end of each year. If inflation of 10% is expected each year, net cash inflows from the sale of each unit would be $11 $(\mathrm{\$}10\times 1.10)$ in year 1 and $12.10 ($\mathrm{\$}11\times 1.10$, or $\mathrm{\$}10\times {\left(1.10\right)}^2$) in year 2, resulting in net cash inflows of $1,100 in year 1 and $1,210 in year 2. The net cash inflows of $1,100 and $1,210 are nominal cash inflows because they include the effects of inflation. Nominal cash flows are the cash flows that are recorded in the accounting system. The cash inflows of $1,000 each year are real cash flows. The accounting system does not record these cash flows. The nominal approach is easier to understand and apply because it uses nominal cash flows from accounting systems and nominal rates of return from financial markets.

Assume that Network Communications can purchase equipment to make and sell an Ethernet blade switch for a net initial investment of $750,000. The equipment is expected to have a 4-year useful life and no terminal disposal value. An annual inflation rate of 10% is expected over this 4-year period. Network Communications requires an after-tax nominal rate of return of 32% (see the previous section). The following table presents the predicted amounts of real (that’s assuming no inflation) and nominal (that’s after considering cumulative inflation) net cash inflows from the equipment over the next 4 years (excluding the $750,000 investment in the equipment and before any income tax payments):

We continue to make the simplifying assumption that cash flows occur at the end of each year. The income tax rate is 40%. For tax purposes, the cost of the equipment will be depreciated using the straight-line method.

Exhibit 22-8 shows the calculation of NPV using cash flows in nominal dollars and using a nominal discount rate. The calculations in Exhibit 22-8 include the net initial bus investment, annual after-tax cash flows from operations (excluding the depreciation effect), and income tax cash savings from annual depreciation deductions. The NPV is $202,513, and, based on financial considerations alone, Network Communications should purchase the equipment.