Question

Briefly explain how capital budgeting relates to inflation and, in general terms, how does capital budgeting could cover companies against inflation?

Answer 1

Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure.

Inflation refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc.

At some point or another, most businesses have to decide whether spending serious money now on capital investment projects will generate a payoff in future. An excellent aid in the decision-making process is capital budgeting. Capital budgeting helps a business to see into the future and figure out the profitability of a long-term investment.

Inflation affects the outcome of capital budgeting in other ways besides the rate of return. Generally, inflation drives up costs for goods and services, including building materials, equipment and labor. These increased costs might render certain projects unfeasible based on the results of the capital budget analysis.

Inflation affects capital budgeting in a significant way. It makes up a part of the market rate of return, and capital budgets reveal the true project cost when using the real rate of return, rather than the market rate. Calculating the real rate of return begins with the market rate of return, then subtracting inflation. This is sometimes stated as its inverse, the real cost of capital.