Investment Appraisal and Inflation

As the cash flows associated with a particular project may span a considerable period of time, it is evident that the level of inflation during that time will affect considerably the profitability of the project. We have pointed out that estimates of future events should take inflation into account, and in Part 3, the distinction between general price level and specific price changes was discussed. We indicated the need to adjust cash-flow forecasts for specific price changes which would affect the enterprise, so as to maintain its operating capability. Accordingly, it is the inflating cost of specific items which are to be taken into account in investment appraisal. The cost of these specific items will exhibit different rates of change, as will the prices of the products containing elements of the specific items of costs. In effect, the existence of a lag between increases in costs and increases in prices may considerably reduce the profitability of a project under conditions of inflation. As the rate of inflation increases, so this problem becomes more acute. For this reason, firms entering into fixed-price contracts extending over a long period of time should arrange for cost-escalation clauses to mitigate the impact of inflation.

The most appropriate method of incorporating the effects of inflation into DCF calculations is to adjust cash-flow forecasts for specific price increases (Scapens, 2018). Such adjusted cash flows are then discounted by the monetary cost of capital. According to some authors, a suitable choice for this purpose is the company's overdraft rate (Cox and Hewgill, 2006).

The impact of inflation is considered in the following terms:

(a) Sales revenues are expected to be adjusted for price changes at the rate of 15 per cent per annum. The adjustment to the annual expected cash inflows from sales is shown below.

(b) Material costs are expected to increase at the rate of 18 per cent per annum. The adjustment for this increase is also shown below.

(c) Labour costs are expected to increase at the rate of 10 per cent per annum.

We can see the manner in which inflation adds a new dimension to the problem of calculating present values. More calculations are involved, and the degree of uncertainty is increased. Many accountants feel that, under conditions of rapid and high inflation, the task of forecasting cash flows over the lifetime of a project covering several years seems somewhat academic. Research has shown that the most popular method of investment appraisal is the payback method, which emphasizes the rate of recovery of investment outlays. During periods of inflation, the payback method places emphasis on projects which have shorter payback periods (Westwick and Shohet, 2006).

Preparing the capital expenditure plan is part of the long-range planning process. The quality of managerial decisions committing the firm's resources to new investments is probably the most significant factor affecting the level of future profitability.

Capital investment decisions encompass two aspects of the long-range profit plan-first, estimating the future net increases in cash inflows or net savings in cash outlays which will result from an investment; second, calculating the total cash outlays required to carry out an investment.

There are three well-known techniques for appraising investment proposals from a financial viewpoint:

(1) the payback method, which emphasizes the length of time required to recoup the investment outlay;

(2) the accounting rate of return, which seeks to express the average estimated yearly net inflows as a percentage of the net investment outlays for the purpose of assessing the profitability of a proposed investment;

(3) discounted cash flow methods, which attempt to evaluate an investment proposal by comparing the present value of the net cash inflows accruing over the life of the investment with the present value of the funds to be invested.

Discounted cash flow techniques provide the most useful procedures for evaluating capital investment proposals. They comprise two methods-the net present value and the internal rate of return. Both methods take into account the time value of money, unlike the other methods mentioned which ignore this factor.

In many situations it is difficult to forecast the time profile of future cash flows with any degree of certainty. The next section considers risk analysis as a means of handling the problem of uncertainty.

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Read on: Gearing and the Cost of Capital

It will be recalled from Part 2 that the distribution of a firm's capital structure as between share capital (equity capital) and fixed interest stock (preference shares and debentures) is known as the gearing. A firm which is highly geared has a higher ratio of fixed interest stock to equity capital. By changing its gearing, a firm may alter its average cost of capital.

It should be noted that financial theorists have argued that it is due only to the influence of a corporation tax system which allows loan interest as a tax deductible expense that gearing is of any significance.
Gearing and the Cost of Capital