To illustrate how inflation should be handled in Investment Appraisal we shall take a simple example, under two different scenarios – an environment with no inflation and an environment where inflation is present:
- No Inflation – suppose you are considering the purchase of a television for RWF1,000. I am undertaking a simple one-year project and I require RWF1,000. I approach you and guarantee you a return of 5% on your investment. Your investment will have grown to RWF1,050 at the end of the year and, in theory, because there has been no inflation the price of the television should still be RWF1,000. Thus, you have made RWF50 in the process and also got your television. Therefore, you have achieved a real return of 5%.
- Inflation (assume 20% per annum) – using the same example as number 1. If you had given me the RWF1,000 this would be worth RWF1,050 at the end of the year but the price of the television would probably have risen to RWF1,200 (+20%) because of inflation, so you would not be able to afford it. The value of your savings has been eroded because of inflation – you have got a return of 5% in money terms but inflation has been running at 20%. Therefore, you have not got a real return of 5% – this is only a nominal (or money) return. In this instance, with inflation of 20% you would require a nominal (money) return of 26% in order to obtain a real return of 5%.REAL v NOMINAL (MONEY) DISCOUNT RATES
Now that you know the difference between a real and a nominal rate of return (or discount rate) which rate should be used in discounting the cash flows of a project? This really depends on how the cash flows are expressed. They can be stated either as:
- Real Cash Flows – stated in today’s prices and exclude any allowance for inflation.
- Nominal/Money Cash Flows – these include an allowance for inflation and are stated in the actual RWF’s receivable/payable.
HANDLING DIFFERENT INFLATION RATES
Where different inputs inflate at different rates the best approach is to inflate each element by the appropriate inflation rate and then to discount the net cash flows (which are now in money terms) by the money rate of return.
. GENERAL CONSIDERATIONS – INFLATION
- Planning – more difficult
- Project Appraisal – another complication
- Interest Rates – higher nominal rates
- Capital – additional capital required
- Borrowings – extra borrowings => increased financial risk for shareholders
- Nature of Borrowings – long v short; fixed v floating; foreign borrowings?
- Selling Prices – can costs be passed on???
- Impact on Customers – delayed payment; bad debts; liquidations etc.