Adjusting cash flow for inflation
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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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 ...
Solution Summary
The solutions discusses the problems associated with adjusting cash flows for inflation when evaluating a project.
Desai Industries is analyzing an average-risk project: Calculate expected NPV
Desai Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. This is just one of many projects for the firm, so any losses can be used to offset gains on other firm projects. What is the project's expected NPV?
WACC 10.0%
Net investment cost (depreciable basis) $200,000
Units sold 48,000
Average price per unit, Year 1 $25.00
Fixed op. cost excl. depr. (constant) $150,000
Variable op. cost/unit, Year 1 $20.20
Annual depreciation rate 33.333%
Expected inflation rate per year 5.00%
Tax rate 40.0%