Question

Inflation is a concept we have all become familiar with in our life. In recent times, inflation has been relatively low. In past years, we have seen inflation above the current low levels.

• What are the key modeling issues we must consider when including inflation in a financial model?
• Why should we include inflation in financial models?

Answer 1

Inflation in general will impact the cash flows projected and used under capital budgeting analysis and financial modeling. But inflation will also have a similar impact on the hurdle rate (discussed in the last paragraph). When conducting a capital budgeting analysis or building financial models, we need to make sure that inflation is treated the same in both the hurdle rate and the cash flow estimates. There are two ways to reflect the effect of inflation in capital budgeting analysis and financial modeling:

• We consider real cash flows and then discount them using real hurdle rate. So, inflation adjusted cash flows are discounted by inflation free discount rate. If the cash flows do not include the impact of inflation, then the inflation rate should be deducted from the discount rate.
• We consider nominal cash flows and we discount them using nominal hurdle rate. A nominal hurdle rate will include inflation premium. Lenders and equity investors will include this to ensure that they are compensated for a loss of purchasing power caused by inflation. It makes sense then that the cash flows should reflect the additional cash flow increases caused by inflation. If the discount rate includes an inflation premium (as it almost always will), then the cash flows should reflect the inflation rate also. In other words, the actual cash flows (after the impact of inflation) should be used.
  

The hurdle rate is the minimum acceptable rate of return on a capital investment project. It should be a reflection of time value of money, inflation premium and risk premium. It can be seen as a compensation desired by an investor for investing into a project. It’s the minimum benchmark return used by an investor to evaluate whether to “go” or “no go” with an investment. A project’s rate of return has to exceed this rate to be selected for investment (and hence this rate is called hurdle rate).