The Impact of Inflation on Capital Budgeting and Working Capital

A major impact on both financial theory and the practice of financial decision making has been the economic instability, especially in prices, evidenced in the U. S. economy since the mid 1960’s. Inflation in the past few years has not been a major macro economic problem, but its spectere, as demonstrated by the Fed’s recent increases in interest rates, is never for the agendas of financial decision makers. Macro economic instability has necessitated that expectations about the future rate of inflation be taken into consideration in making decision(s) about which capital projects will be undertaken by a firm.

Nominal cash flows determine its degree of profitability. However, in making the capital budgeting decision both real and nominal concepts must be considered. The purpose of this paper is to continue the discussion of the role of inflation in capital budgeting, and to focus on the individual components of the process to draw specific conclusions with respect to the interaction between the cost of capital, inflation, and the cash flow variables within a DCF – IRR framework.

Much research has been published examining the impact of inflation on the capital budgeting decision making process, and, although inflation is not currently a serious problem, bitter lessons from the 1975-1985 period of rapid price increases, coupled with the potential of future inflation, argue for continued research in this field. In a famous article, Rappaport and Taggart examined various methods for incorporating the effect of inflation into capital budgeting.

They provided an analysis which showed the differential impact of using a gross profit per unit approach, a nominal cash flow approach (where individual forecasts are incorporated into each component of cash flow) and a real cash flow approach in which a general price deflator is used to deflate nominal cash flows. In another early article dealing with the subject, Van Horne showed that to be consistent, inflation in forecasting cash flows must also be reflected in a discount rate containing inflation; that is, a bias was introduced if nominal cash flows were discounted at the real and not nominal cost of capital.

Cooley, Roenfeldt and Chew revealed the mechanics by which inflation adjustments can be incorporated into the capital budgeting process. At the same time, Nelson demonstrated the theoretical impact of inflation on capital budgeting and showed how inflation would shift the entire NPV schedule of a capital budget downward for a set or projects. Bailey and Jensen have analyzed how price level adjustments affect the process in detail and specifically how various price level adjustments might change the ranking of projects.

Rappaport and Taggart attempt to combine the simplicity of a gross profit per unit methodology of adjusting for inflation with the more realistic nominal case flow and real cash flow approaches. A gross profit per unit focus on Revenues – Cost of Sales divided by units, and can treat inflation by simply inflating this gross profit per unit as opposed to measuring inflation for both revenues and cost of sales. This is done by making the simplifying assumption that gross margin as a percent of sales is constant over time, which they point out is the same as assuming that EBIT is a constant percentage of sales over time, or that revenues and costs increase at the same rate. In this paper we examine a number of issues raised by Rappaport and Taggart in the area of inflation and capital spending.

Specifically, we will analyze the following areas:

• What is the relationship between the cost of capital and inflation?
• What is the relationship between inflation in the aggregate and the price a firm places on its specific product that results from a capital budgeting decision?
• Assuming costs rise at the aggregate or average rate of inflation, what can we say about expectations of the price of output of the firm?
• What role do depreciable and non-depreciable assets play in the interaction of the variables? How does the presence of plant and equipment as a depreciable asset and the presence of net working capital as a nondepreciable asset impact on the role of inflation in the capital budgeting process?