The Effects of Inflation on Investment Appraisal

Before the widespread use of computer-assisted forecasting and modelling, investment appraisals often took no account of inflation rates. With inflation, prices keep rising and nominal currency amounts buy decreasing amounts of goods and services over time. Investors will need to account for this, particularly in emerging economies with relatively high inflation rates. A contemporary investment appraisal considers all three discount rates: nominal money rates, real rates and inflation rates. A sophisticated appraisal also includes projections that take into account the uncertainty of future rates of inflation.

Cash flows critically determine the viability of a proposed investment. As an investor, you want to know the average rate of return, called ARR, on your investment. Initially, you can find the ARR by comparing annual cash flows with the initial cost of your investment. In one analysis, for example, you conclude that over seven years the ARR equals 9 per cent. However, the ARR method does not account for inflation. If inflation equals 10 per cent per annum, the real value of the money you used to make your initial investment declines by 50 per cent over 10 years, reducing future cash flows accordingly. The value of the money received at future times declines in proportion with inflation. The ARR method does not account for this. You will obtain more realistic results by using an appraisal method that incorporates the inflation rate in the decision.

A net present value assessment of an investment takes into account the inflation rate and gives you the real return rate on your money. If the inflation rate, for example, equals 5 per cent, then the discount factor for year one equals .952 per cent, and successive discounts for years two through five equal .907, .864, .823 and .784. To find the real rate of return accounting for inflation, multiply the nominal rate of return by the discount percentage for each year. If the ARR equals 7 per cent, the real return rates decline over these five years to 6.7, 6.4, 6.0, 5.8 and 5.5. Note that by the fifth year the real return rate has declined nearly to the inflation rate.

Inflation has unpredictable effects on consumer demand. If a company attempts to counter a 15 per cent annual inflation rate with annual price increases of 15 per cent, product demand may fall precipitously. If a company attempts to mitigate this by raising prices by less than the inflation rate, profits will fall. Inflation will also affect financing. In general, as inflation rises the cost of capital rises with it. In general, a company must either retain more of its earnings to purchase assets or must retain earnings to pay the higher cost of financing those assets. The investment appraisal must account for these negative inflationary effects.

Inflation uncertainty makes investment appraisals difficult. New appraisal methods incorporate this uncertainty into an appraisal and, instead of proposing specific future cash flows, conducts risk analyses of the data, then describes a range of outcomes, assigning to each a risk probability. This gives investors a more realistic view because it quantifies the uncertainty inherent in the investment.