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Adjusting cash flow for inflation

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In the analysis John drew your attention to the fact that whereas you were using the market-determined nominal cost of capital as the discount rate, the sales price and operating cost per unit were assumed to remain constant throughout the project's life. This raised the following questions

a. What are the problems with an analysis in which the discount rate is in nominal terms but the cash flows are measured in current dollar terms, unadjusted for inflation?

b. If cash flows are to be adjusted for inflation, is it appropriate to assume that inflation is neutral, i.e., that inflation has the same impact on all elements of the cash flow stream?

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Solution Summary

The solutions discusses the problems associated with adjusting cash flows for inflation when evaluating a project.

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a. What are the problems with an analysis in which the discount rate is in nominal terms but the cash flows are measured in current dollar terms, unadjusted for inflation?

If the discount rate is in nominal terms but the cash flows are measured in current dollar terms, unadjusted for inflation then there is problem of inconsistency. Thus the numerator (cash flow) in the NPV calculations is unadjusted for inflation while the discount rate in the ...

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