Capital Budgeting under inflation

Question 1

What are the two different methods of analysis under inflation? What’s their definition?

Answer 1

Nominal prices = estimation of CF at current prices (Variation in quantity and price)
Real prices = estimation of CF at constant prices (variation only in quantities)

Question 2

What’s the relationship between nominal and real prices regarding inflation rate?

Answer 2

(1+nominal rate) = (1+real rate)*(1+inflation rate)

Question 3

What’s the difference between contratual and noncontrational CF’s?

Answer 3

Contratual = fixed in nominal euro terms
Noncontratual = revenues and costs can fluctuate in line with changing market conditions.
–> Neutrality Inflation is a good first approach to carry out a capital budgeting analysis.

Question 4

Typically, tax system taxes nominal income, Depreciation is based on historical cost and tax shield from depreciation is a nominal value. What’s the consequence of not deflating the depreciation amount using the real prices approach?

Answer 4

The NPV of the project will be overstated.

Question 5

Name three attributes of real prices:

Answer 5

• easier to estimate
• avoids estimation of different inflation rates if inflation is non neutral
• needs an expectation about the median inflation rate of the economy

Question 6

Name two attributes of nominal prices approach:

Answer 6

• Preferable if inflation is non neutral and we can estimate the different inflation rates related to the specific rubric;
• Only this method allows the construction of a financial plan adequate to reality, showing the financial needs (or surplus) of each period

Question 7

What approach is preferred in cases of high inflations?

Answer 7

Real prices, because the annual items are registered in terms of equal purchasing power (at zero year prices)
Alternatively it’s benefitial to use a more stable currency.

Question 8

Name six important things when using the project CF approach:

Answer 8

Only CF must be considered
CF are after taxes
Include side effects
ignore sunk costs
include opportunity costs
be aware of overheads