Question

(Identifying nominal numbers) A company is considering an investment that would cost $25,000 and return a net after-tax cash flow of $8,000 per year in each of the next five years.

a. Assume these figures include inflation forecasts. What numbers should enter the capital budgeting analysis?

b. Now assume the above figures do not include inflation, forecast to be 6% per year. What numbers should enter the capital budgeting analysis?

c. Why must the cash flows used in capital budgeting contain the impact of inflation?

d. What would be the bias if the impact of inflation were left out

Answer 1

a]	The numbers that should enter the CB anlysis are the yearly cash flows as given below:
		0	1	2	3	4	5
	Cash flows	$       -25,000	$         8,000	$         8,000	$       8,000	$        8,000	$        8,000
b]	The numbers that should enter the CB anlysis are the yearly cash flows adjusted for inflation. They are given below:
		0	1	2	3	4	5
	Cash flows	$       -25,000	$         8,480	$         8,989	$       9,528	$      10,100	$      10,706
	Note: It is presumed that the $8000 of net after tax cash flow is given as of t0 [today]. Hence, inflation has been applied
	for the 1st year cash inflow itself.
c]	If inflation is not considered the benefits calculated [NPV] would be wrong leading to inappropriate decisions.
d]	If inflation is left out it would generally tend to overstate benefits.