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 [14] 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 [16] showed that to be consistent,