The Impact of Inflation on Capital Budgeting and Working Capital

A study impact on both financial theory and the practice of financial finish making has been the stinting instability, especially in hurts, evidenced in the U. S. economy since the mid 1960s. pretension in the past few years has not been a major macro economic problem, but its spectere, as demonstrated by the feeds 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 largeness be taken into consideration in making decision(s) about which heavy(p) projects will be undertaken by a firm.Nominal funds flows picture its degree of profitability. However, in making the uppercase budgeting decision both substantive and nominal concepts must be considered. The purpose of this paper is to continue the banter of the role of ostentatiousness in capital budgeting, and to concentrate on on the soul components of the functioning to draw specific conclusions wi th respect to the fundamental interaction between the price of capital, pretension, and the cash flow variables within a DCF IRR framework.Much research has been print examining the impact of pompousness on the capital budgeting decision making process, and, although inflation is not currently a serious problem, bitter lessons from the 1975-1985 period of fast price increases, coupled with the potential of future inflation, argue for continued research in this field. In a famous article, Rappaport and Taggart 14 establishd various methods for incorporating the effect of inflation into capital budgeting.They provided an analysis which showed the differential impact of using a tax revenue profit per unit attack, a nominal cash flow approach (where individual forecasts are incorporated into each component of cash flow) and a existent cash flow approach in which a commonplace price deflator is used to deflate nominal cash flows. In some other early article dealing with the subject, Van Horne 16 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 court of capital.Cooley, Roenfeldt and Chew revealed the mechanics by which inflation adjustments can be incorporated into the capital budgeting process 6. At the same time, Nelson 12 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 1 have study 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 gro ss profit per unit focus on Revenues Cost of Sales divided by units, and can conduct 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 per centum of sales is constant over time, 14, p. 2 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 1. What is the relationship between the cost of capital and inflation? 2. What is the relationship between inflation in the gist and the price a firm places on its specific product that results from a capital budgeting decision?Assuming costs rise at the pith or average rate of inflation, what can we say about expectations of the price of output of the firm? 3. 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 bread working capital as a nondepreciable asset impact on the role of inflation in the capital budgeting process?