# Making Hard Capital Budgeting Decisions Finance Essay

In today’s complex business environment, making capital budgeting decisions are among the most important and multifaceted of all management decisions as it represents major commitments of company’s resources and have serious consequences on the profitability and financial stability of a company. It is important to evaluate the proposals rationally with respect to both the economic feasibility of individual projects and the relative net benefits of alternative and mutually exclusive projects. It has inspired many research scholars and is primarily concerned with sizable investments in long-term assets, with long-term life.

In the allocation of capital to investment projects, it is unlikely that optimal decisions will be reached unless anticipated inflation is embodied in the cash-flow estimates. Often, there is a tendency to assume that price levels remain unchanged throughout the life of the project. Frequently this assumption is imposed unknowingly; future cash flows are estimated simply on the basis of existing prices. However, a bias arises in that the cost-of-capital rate used as the acceptance criterion embodies an element attributable to anticipated inflation, while the cash-flow estimates do not. Although this bias may not be serious when there is modest inflation, it may become quite important in periods of high anticipated inflation.

## Problem statement

The growing internationalization of business brings stiff competition which requires a proper evaluation and weight age on capital budgeting appraisal issues viz. differing project life cycle, impact of inflation, analysis and allowance for risk. Therefore financial managers must consider these issues carefully when making capital budgeting decisions. Inflation is one of the important parameters that govern the financial issues on capital budgeting decisions. Financial managers of developed countries and low inflation rate countries such as USA, Canada, Japan and Malaysia are able not to consider inflation on their capital investment decisions but financial managers of developing and least developed countries need to consider effects of inflation on capital investment decisions because of high level of inflation. Nevertheless, we think both countries’ financial managers should consider effects of inflation on capital investment decisions.

In practice, the managers do recognize that inflation exists but rarely incorporate inflation in the analysis of capital budgeting, because it is assumed that with inflation, both net revenues and the project cost will rise proportionately, therefore it will not have much impact. However, this is not true; inflation influences two aspects viz. Cash Flow, Discount Rate and hence goal of our project paper is an attempt to analyze the issues in the area of effects of inflation on capital budgeting decisions for optimum utilization of scarce resources.

## 1.3. Research question

How can inflation effect on cash flows?

How does inflation effect on discount rate?

How managers can avoid bad effects of inflation to capital investment?

Are there any alternative methods of estimating cash flows when inflation exists?

## Objectives

The objectives of this research project are to:

Identify effects of inflation on capital investment decisions;

Evaluate effects of inflation on cash flows and discount rate;

Assess critically effects of inflation on capital investment;

Examine alternative methods of estimating capital investment decisions.

## Chapter II

## 2.1. Literature review

## 2.1.1. Overview of inflation

Inflation means the fall in the value of money. For analyzing capital budgeting decision with inflation we need to differentiate expected and unexpected inflation rate. “The difference between unexpected and expected inflation is of crucial importance as the effects of inflation, especially its redistributive effect, depend on whether it is expected or not. Expected inflation refers to the loss the manager anticipates in buying power over time whereas unexpected inflation refers to the difference between actual and expected inflation. If rate of inflation is expected, then the manager take steps to make suitable adjustments in their proposals to avoid the adverse effects which could bring to them.”

Inflation is measured by calculating a large number of products and services’ price change, these data are collected by government agencies. The prices of goods and services are combined to give a price index or average price level, the average price of the basket of products. There are different methods of measuring inflation rate in economy such as calculating based on consumer basket of goods and services, producer basket of goods and services. Therefore, there are some common inflation measures:

Consumer Price Indexes (CPIs);

Producer Price indexes (PPCs);

Wholesale Price Indexes (WPIs);

Commodity Price Indexes;

GDP deflator;

Employment Cost index.

Inflation and GDP growth are probably the two most important macroeconomic variables. The Gross Domestic Product (GDP) is the key indicator used to measure the health of a country's economy. The GDP of a country is defined as the market value of all final goods and services produced within a country in a given period of time. Usually, GDP is expressed as a comparison to the previous quarter or year. Inflation and GDP growth are probably the two most important macroeconomic variables. The Gross Domestic Product (GDP) is the key indicator used to measure the health of a country's economy. The GDP of a country is defined as the market value of all final goods and services produced within a country in a given period of time. Usually, GDP is expressed as a comparison to the previous quarter or year.

## 2.1.2. Inflation and Capital Budgeting Decision

Capital budgeting results would be unrealistic if the effects of inflation are not correctly factored in the analysis6.For evaluating the capital budgeting decisions; we require information about cash flows-inflows as well as outflows. In the capital budgeting procedure, estimating the cash flows is the first step which requires the estimation of cost and benefits of different proposals being considered for decision making. The estimation of cost and benefits may be made on the basis of input data being provided by experts in production, marketing, accounting or any other department. Mostly accounting information is the basis for estimating cash flows.

Inflation and Cash Flows: Estimating the cash flows is the first step which requires the estimation of cost and benefits of different proposals being considered for decision-making. Usually, two alternatives are suggested for measuring the 'Cost and benefits of a proposal i.e., the accounting profits and the cash flows. In reality, estimating the cash flows is most important as well as difficult task. It is because of uncertainty and accounting ambiguity.

Effects of Inflation on Cash Flows: Often there is a tendency to assume erroneously that, when, both net revenues and the project cost rise proportionately, the inflation would not have much impact. These lines of arguments seem to be convincing, and it is correct for two reasons. First, the 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 cash flows which are not adjusted for the impact of inflation. Second, selling prices and costs show different degrees of responsiveness to inflation. Estimating the cash flows is a constant challenge to all levels of financial managers. To examine the effects of inflation on cash flows, it is important to note the difference between nominal cash flow and real cash flow. It is the change in the general price level that creates crucial difference between the two. A nominal cash flow means the income received in terms rupees. On the other hand, a real cash flow means purchasing power of your income. The manager invested Rs.10000 in anticipation of 10 per cent rate of return at the end of the year. It means that the manager will get Rs.11000 after a year irrespective of changes in purchasing power of money towards goods or services. The sum of Rs.11000 is known as nominal terms, which includes the impact of inflation. Thus, Rs. 1000 is a nominal return on investment of the manager. On the other hand, (Let us assume the inflation rate is 5 percent in next year. Rs.11000 next year and Rs.10476.19 today are equivalent in terms of the purchasing power if the rate of inflation is 5 per cent.) Rs.476.19 is in real terms as it adjusted for the effect of inflation. Though the manager’s nominal rate of return is Rs. 1000, but only Rs. 476 is real return. The same has been discussed with capital budgeting problem.

Inflation and Discount Rate: The discount rate has become one of the central concepts of finance. Some of its manifestations include familiar concepts such as opportunity cost, capital cost, borrowing rate, lending rate and the rate of return on stocks or bonds11. It is greatly influenced in computing NPV. The selection of proper rate is critical which helps for making correct decision. In order to compute net present value, it is necessary to discount future benefits and costs. This discounting reflects the time value of money. Benefits and costs are worth more if they are experienced sooner. The higher the discount rate, the lower is the present value of future cash flows. For typical investments, with costs concentrated in early periods and benefits following in later periods, raising the discount rate tends to reduce the net present value. Thus, discount rate means the minimum requisite rate of return on funds committed to the project. The primary purpose of measuring the cost of capital is its use as a financial standard for evaluating investment projects.

Effects of Inflation on Discount Rate: Using of proper discount rate, depends on whether the benefits and costs are measured in real or nominal terms. To be consistent and free from inflation bias, the cash flows should match with discount rate. Considering the above example, 10 per cent is a nominal rate of return on investment of the manager. On the other hand, (Let us assume the inflation rate is 5 per cent, in next year), though the manager’s nominal rate of return is 10 per cent, but only 4.76 percent is real rate of return. In order to receive 10 per cent real rate of return, in view of 5 per cent expected inflation rate, the nominal required rate of return would be 15.5%. The nominal discount rate (r) is a combination of real rate (K), expected inflation rate (α). This relationship is known as Fisher’s effect, which may be stated as follows: The relationship between the rate of return and inflation in the real world is a tough task to explain than the theoretical relationship described above. Experience shows that deflation of any series of interest rates over time by any popular price index does not yield relatively constant real rates of interest. However, this should not be interpreted as the current rate of interest is properly adjusted for the actual rate of inflation, but only that it will contain some expected rate of inflation. Furthermore, the ability of accurately forecasting the rate of inflation is very rare

## CHAPTER III

## Discussion

We want to consider the possible impact of future inflation on Capital Budgeting decisions. One of the most important concepts that we need to master is the impact of expected inflation on the required returns we observe in Capital Markets. The fundamental relationship here is the Fisher Effect. Fisher’s fundamental insight is that Capital Market participants are always guessing what future inflation will be and building these guesses of future inflation into theyields on the securities that they buy and sell.

Clearly, inflation can erode the actual return that we receive on an asset. The object of saving or investing, is supposed to be to consume more in the future.But if the annual inflation rate has been equal or gigger than the annual investment return, the investment will be for nothing in terms of purchasing power, because the same number of goods could be bought at the end of the interval as the beginning.Fisher argues that Capital Markets should constantly be assessing future inflation and building that guess into interest rates. He posited that there is a real rate of interest in addition to the nominal rate that we observe in the market. Where the Fisher Effect is normally presented as: rnominal = rreal + iexpected inflation

Now lets think about a Capital Budgeting situation. First, we are supposed to estimate our firm’s Weighted-Average-Cost-of-Capital (WACC). To do this we have to estimate the current required returns of the firm’s securityholders. However, when we estimate these yields on the stocks and bonds, we know we that these are nominal ratesthat include the guesses of future inflation.

On the other hand, we need to think of what goes on when we make up our guesses of sales and cost-of-goods-sold.We are probably thinking in terms of today’s prices and are projecting them forward. In short, we have to think about whether our sales and cost-of-goods-sold are real or nominal. Have we included a growth factor for inflation or not?

In order to enrich our discussion we will provide the following example: We are considering an investment in a machine that will cost $300.We will depreciate the machine by the straight-line method, over three years, down to a value of zero. The machine will have no salvage value. We expect annual gross profits to be $140 (for instance we expect to sell 140 widgets for$2 each, and the cost-of-goods-sold is $1 per widget; this clearly implies that we are holding prices constant and not adjusting for inflation, these are real gross profit figures). Our firm operates in a 35% marginal tax bracket, and theWACC is 15%. The presumption is that we computed WACC directly from the market prices for the securities, so itcontains the expected inflation, and is a nominal rate.

0 1 2 3

Gross Prof 140 140 140

Deprec 100 100 100

Taxable Inc 40 40 40

Tax 35% 14 14 14

Net Inc 26 26 26

CF -300 126 126 126

Desision: By using nominal WACC of 15% to discount real cashflow figures the NPV =($12.31) . It is a negative NPV project so we would reject it. But we need here to notice that we have used a nominal rate to discount real cashflows, and this logically incorrect and leads us to a misleading results.

-What if we thought annual inflation would really be 5% during the life of this project? Now we could adjust our sales and cost-of-goods-sold figures accordingy. If we dothis, we now have nominal cashflow estimates and nominal rates.

0 1 2 3

Gross Prof 147 154.35 162.0675

Deprec 100 100 100

Taxable Inc 47 54.35 62.0675

Tax 35% 16.45 19.0225 21.72363

Net Inc 30.55 35.3275 40.34388

CF -300 130.55 135.3275 140.3439

Desision: By using nominal WACC of 15% to discount nominal cashflow figures the NPV= $8.13 It is a positive NPV project so we would accept it.

We can see from this example the kind of bias we are likely to introduce into Capital Budgeting decisions. When we mix real cashflows with nominal interest rates, we are, in fact, using inappropriately high discount factors.Therefore, at the margin, we would have a tendency to reject good value enhancing projects.

Another way to attack the problem is to leave the cashflow estimates in real terms and just use the Fisher Effect formula (rnominal = rreal + iexpected inflation) to estimate a real required return. this implies that the real rate is roughly 10%. Hence, we can take the first set of cashflow estimates, and discount them at 10%:

0 1 2 3

Gross Prof 140 140 140

Deprec 100 100 100

Taxable Inc 40 40 40

Tax 35% 14 14 14

Net Inc 26 26 26

CF -300 126 126 126

Desision: By using real WACC of 10% to discount real cashflow figures the NPV= $13.34

We need to notice that the NPV here is much higher than in the previous,correctly executed example.

In this third approach,we are going to adjust depreciation for inflation. If the 5% inflation really occurs, the annual gross profit figures will be greater than $140. Therefore, we(by using real cashflows) are actually over estimating the amount of our real income that will be shielded from taxes, and hence, underestimating the real amount of taxes paid. This should make it clear that by trying to mix real cashflows and real rates in this way, we have created a slight bias in favor of accepting a bad project. If we want do it right, it is necessary to decrease the depreciation figures by 5% per year.

0 1 2 3

Gross Prof 140 140 140

Deprec 95.2381 90.70295 86.38376

Taxable Inc 44.7619 49.29705 53.61624

Tax 35% 15.66667 17.25397 18.76568

Net Inc 29.09524 32.04308 34.85056

CF -300 124.3333 122.746 121.2343

Desision: By using real WACC of 10% to discount real cashflow figures the NPV = $5.56

We can notice that the NPV of $5.56 is much closer to the $8.13 than the $13.34. This is because the 10% figure for the real rate isn’t quite right. In fact, if we use the 15% nominal rate and the 5% expected inflation in the more exact Fisher Effect formula [rnominal = rreal + iexpected inflation + (rreal x iexpected inflation)], we can calculate an exact real rate of 9.52381%. If we discount the cashflows above at this rate,we can get an NPV of $8.13,exactly the same as the approach using nominal cashflows and nominal rates.

## CHAPTER IV

## Conclusion

It could be inferred from the above analysis that, effects of inflation are significantly influenced on capital budgeting decision making process. Though the inflation is a common problem, every finance manager encounters during their capital budgeting decision making process for optimum utilisation of scarce resources especially in two major aspects namely cash flow and discount rate. To examine the effects of inflation on cash flows, it is important to note the difference between nominal cash flow and real cash flow. It is the change in the general price level that creates crucial difference between these two. We could conclude that Probably the most common mistake would be to combine real cashflow estimates with nominal interest rates. We have seen that this creates a marginal bias for rejecting projects that are truly good. The best way to correct such a bias is to adjust the real estimates of sales and cost-of-goods-sold for inflation, making them nominal figures; then to discount at the nominal rates. Therefore, the finance manager should take into cognizance the effect of inflation. Otherwise possibilities are more to foregothe good investment proposal, because of low profitability.

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