Inflation and long-term projects

When a company makes a long-term investment, there will be costs and benefits for a number of
years. In all probability, the future cash flows will be affected by inflation in sales prices and
inflation in costs.

In practice, it is common to ignore inflation when carrying out DCF analysis for investment
appraisal. Inflation can be ignored if it can be assumed that:
 There will be no inflation in prices and costs.
 It is impossible to predict what inflation will be, but the effects of inflation will be
insignificant.
 All cash flows, for benefits and costs, will have exactly the same rate of inflation.
It is certainly difficult to predict what the rate of inflation will be over the next few years, and this
is probably why inflation is normally ignored for DCF analysis.

However, inflation might be a significant factor in some investments. Inflation should be taken
into consideration:
 When it is likely to be significant.
 When reasonable estimates of the future rate of inflation can be made.

When estimates are made for inflation in future cash flows, the rules are as follows:
 Estimate all cash flows at their inflated amount. Since cash flows are assumed to occur at
the year-end, they should be increased by the rate of inflation for the full year.
 To estimate a future cash flow at its inflated amount, you can apply the formula:
Cash flow in year n at inflated amount = [Cash flow at current price level] × (1 + i) n
Where i is the annual rate of inflation.
 Discount the inflated cash flows at the money cost of capital, to obtain present values for
cash flows in each year of the project and the NPV for the project.

Illustration:-

A company is considering an investment in an item of equipment costing KShs.150, 000. The

equipment would be used to make a product. The selling price of the product at today’s prices
would be KShs.10 per unit, and the variable cost per unit (all cash costs) would be KShs. 6.
The project would have a four-year life, and sales are expected to be:
Year Units of sale
(KShs)
1 20,000
2 40,000
3 60,000
4 20,000

At today’s prices, it is expected that the equipment will be sold at the end of Year 4 for KShs10,
000. There will be additional fixed cash overheads of $50,000 each year as a result of the project,
at today’s price levels.
The company expects prices and costs to increase due to inflation at the following annual rates:

Items Inflation
Sales 5%
Variable Costs 8%
Fixed Costs 8%
Equipment disposal Value 6%

The company’s money cost of capital is 12%. Ignore taxation.

Required
Calculate the NPV of the project.

Solution
Illustration 2:
A company is considering whether or not to invest in a five-year project. The investment will
involve buying an item of machinery for KShs 200,000. At today’s prices, the annual operating
cash flows would be:

Year Revenue Running Costs

(KShs) (KShs)
1 200,000 100,000
2 200,000 100,000
3 250,000 125,000
4 150,000 75,000
5 100,000 50,000

However, revenues are expected to go up by 7% each year due to inflation, and costs are expected
to go up by 12% per year due to inflation.

The machinery is expected to have a re-sale value at the end of year 5 of KShs 20,000 at today’s
prices, but this amount is expected to rise by 5% each year due to inflation.

The cost of capital is 16%. Ignore Taxation and depreciation.

Required
Calculate the NPV of the investment project.

Real cost Vs. Nominal (money) cost

A Nominal cost is a cost that includes an allowance for inflation. A real cost is a cost that excludes
the effects of inflation. Real costs have to be expressed in terms of prices at a given date. In DCF
analysis this will normally be ‘today’s prices’.

A real rate of return can be calculated using the relationship

(1 + nominal rate) = (1 + real rate) × (1 + inflation rate) where all of the rates are expressed as
proportions.

If a company has a cost of capital of 12% and inflation is 5%

(1 + Nominal Rate) = (1 + 0.12) × (1 + 0.05) = 1.176 therefore nominal rate = 1.176-1=0.176=
17.6%

Illustration:

Talanta Co is a listed company which plans to meet increased demand for its products by buying
new machinery costing Ksh.5 million. The machinery would last for four years, at the end of which
it would be replaced. The scrap value of the machinery is expected to be 5% of the initial cost.
Capital allowances would be available on the cost of the machinery on a 25% reducing balance
basis, with a balancing allowance or charge claimed in the final year of operation.
This investment will increase production capacity by 9,000 units per year and all of these units are
expected to be sold as they are produced. Relevant financial information in current price terms is
as follows:
Forecast inflation
Selling price Ksh.650 per unit 4·0% per year
Variable cost Ksh.250 per unit 5·5% per year
Incremental fixed cost Ksh.250, 000 per year 5·0% per year

In addition to the initial cost of the new machinery, initial investment in working capital of
Ksh.500, 000 will be required. Investment in working capital will be subject to the general rate of
inflation, which is expected to be 4·7% per year.
Talanta Co pays tax on profits at the rate of 20% per year, one year in arrears. The company has a
nominal (money terms) after-tax cost of capital of 12% per year.
Required:
(a) Calculate the net present value of the planned purchase of the new machinery using a nominal
(money terms) approach and comment on its financial acceptability. (14 marks)
(b) Discuss the difference between a nominal (money terms) approach and a real terms approach
to calculating net present value. (5 marks)
(c) Identify TWO financial objectives of a listed company such as HDW Co and discuss how each
of these financial objectives is supported by the planned investment in new machinery. (6 marks)