Effect of Inflation on NPV and Net Working Capital
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Why is it true, in general, that a failure to adjust expected cash flows for expected inflation biases the calculated NPV downward?
Explain how net operating working capital is recovered at the end of a project's life, and why it is included in a capital budget analysis.
Define (a) simulation analysis, (b) scenario analysis, and (c) sensitivity analysis.
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Solution Summary
The solution explains the reason behind the bias in NPV due to inflation not being taken into account. This is followed by the ways in which net working capital is recovered at the end of a project and brief explanations of simulation analysis, scenario analysis and sensitivity analysis.
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1. Why is it true, in general, that a failure to adjust expected cash flows for expected inflation biases the calculated NPV downward?
The main idea of computing NPV (Net Present Value), as a part of the investment appraisal process, is to take the time value of money into account. However, it is interesting to note that the cost of capital is taken as the minimum rate of return required for the project and hence used as the discount factor.
An important factor which affects the time value of money is inflation. Hence it is essential to include the effects of expected inflation in the NPV calculations. When a computed NPV does not include the effects of inflation, then it is biased.
Inflation causes the discount rate to increase, i.e., upwardly ...
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