Inflation effect

Assume that a firm wishes to make an investment now to provide 100,000 in cash at the end of each year for the next ten years. The firm expects to receive a 10 percent return (i = 0.10) on its investment irrespective of inflation effects. However, the firm also wishes to account for an assumed annual inflation of 7 percent ( inflation = 0.07) so that the dollars its invests now are corrected for the fact that these dollars will be worth less in the future. Under these conditions, the question is how to establish the correct discount factor to determine the investment the firm needs to make at this time. In other words, what is the total present value of the future annual incomes of 100,000 for 10 years discounted for both return on investment and inflation ... 

The preceding example clearly shows that inflation effects can be important in determining returns on investment. The best strategy for handling such effects is to use the discounted-cash-flow or present-worth method for reporting returns on investment with the results based on the after-tax situation. This method of reporting can be handled easily and effectively by use of an appropri-... 

The idea that first-row heteroatoms, in the order C 2.5), N 3.1) and 0(3.5), when substituted for B 2.0) might tend increasingly to favor the ni-6 structure seems to be valid, see Figure 8. There also seems to be an even stronger second-row inflation effect in that sulfur, S 2.4), with an electronegativity less than carbon, C 2.5), has an influence half way between N 3.1 and 0(3.5). We would suspect that phosphorous and silicon substitution for boron would have similar second-row inflation effects . 

This is further complicated in making allowance for inflation effects and life-cycle costing. The normal US practice is to use a factor of about 3% as the normal difference between inflation and interest rates. However, in the United Kingdom the Treasury requires a 7% discount rate as the difference between inflation and the cost of a commercial loan (Unwin and Hall, 1993). This has a highly distorting effect on all life-cycle costing for UK highway structures. 

The deflation effect is transmitted by a series of impulses different from those responsible for the inflation effect. Indeed, if the vagus nerves are cooled below 8° C, response to deflation continues. Little is known of the mechanism and the physiological significance of these reflexes. 

One-way RM ANOVAs using the techniques as the independent variable were conducted to analyze questionnaire results. Bonferroni corrections were used for multiple comparisons and Greenhouse-Geisser corrections were used when sphericity could not be assumed. For the purpose of the analyses, data were recoded such that greater numbers are better. To account for experiment-wise alpha inflation, effects with significance levels above. 003 (.05/17) should be interpreted with caution. 

As the discount rate increases then the NPV is reduced. The following diagram shows the cashflow from the previous example (assuming an oil price of 20/bbl and ignoring the effect of inflation) at four different mid-year discount rates (10%, 20%, 25%, 30%). 

Hardly a raw material used by the chemical industry has been unaffected by the continuing ripple effect of on-and-off inflation. Raw material prices have not risen evenly. Shifts in relative prices of competing materials continue to occur. Healing with these shifts is a significant challenge to market research and chemical buyer personnel. It must be stressed that a total view of prices, availabiUty, and competing demands is now required and developments must be constandy monitored. 

Inflationary Effects. Inflation can have a significant effect on the profitabiUty of a venture. However, the U.S. federal tax laws do not allow for indexing the inflationary effects on depreciation schedules, salvage values, replacement costs, or taxable income. Inflation rates can vary unpredictably with time and can differ for certain revenues of expenditures. 

The following example illustrates the effect of inflation on (NPV) as well as on the taxes the company pays. 

Ejfect of Inflation on (DCFRB.) A net annual cash flow Acpvvill have a cash vaJue of Acf(1 + i) 1 year later if invested at a fractional interest rate i. If there is inflation at an annual rate h, then an effective rate of return or interest rate can be defined by the equation... 

FIG. 9-29 Effect of inflation rate on net present value for a project. 

Instead of using Eq. (9-113), it is unfortunately common practice to try to obtain the true or effective rate of return by calculating the nominal (DCFRR), based on actual net annual cash flows uncorrected for inflation, and then subtracting the inflation rate from it as if... 

Equation (9-113) shows that Eq. (9-114) is only approximately true and should be used, if at all, solely for low interest rates. Let us consider the case of a nominal (DCFRR) of 5 percent and an inflation rate of 3 percent. Equation (9-14) yields an approximate effective return rate of 2 percent, compared with the real effective rate of 1.94 percent given by Eq. (9-113) i.e., there is an error of 3.1 percent. Now let us consider the case of a nominal (DCFRR) of 2.5 percent and an inflation rate of 23 percent. Equation (9-114) yields an approximate effective return rate of 2 percent, compared with 1.63 percent from Eq. (9-113) in this case, the error that results is 22.7 percent. 

Inflation (DCFRR) and Payback Period More insight into the effect of inflation on (DCFRR) calculations can be gained dv considering the payback period (PBP), which is defined as the elapsed time necessary for the positive aftertax cash flows from the project to... 

The relationship set out in Eq. (9-115) can also be viewed via a different chain of causality with (DCFRR) as a given parameter, (PBP) as the independent variable, and n as the variable whose value is being sought. Such an approach is the basis for the lines in Fig. 9-31, each of which shows the number of years of projec t life required to achieve an effective interest rate or a (DCFRR) of 20 percent by projects having various payback periods. The three hues differ from each other with respec t to the matter of inflation. 

FIG. 9-31 Effect of inflation rate on the relationship between the payback period and the discounted-cash-flow rate of return. 

Figure 9-31 shows that the elapsed time necessary to reach a nominal (DCFRR) for a given project decreases sharply with inflation. This figure, hke Fig. 9-29, shows that the effect of inflation is to make a projec t seem more profitable than it ac tuaUy is. 

The magnitude of the effect comes through even more clearly in Fig. 9-32, a plot of the time needed to reach a nominal (DCFRR) of 20 percent against the inflation rate for various values of (PBP). This plot also shows that the longer the payback period, the greater the increase in apparent profitability of the project. 

FIG. 9-32 Adverse effect of inflation for higher payback periods. 

Effects of Differential Inflation Inflation can be general or differential. In the first case, all costs and prices increase at a uniform rate. In the second, government controls and other factors cause the various costs and prices to inflate at different rates. 

Let us consider the effect of differential inflation on the overall profitability of the project of the last example. The effect of general inflation on this project showed that the apparent profitability rises sharply, to an (NPV) of 431,269 at a general inflation rate of 20 percent. However, when the cash flows of the (NPV) are properly corrected to their purchasing power in Year 0, the (NPV) instead becomes 208,733. 

The effect of differential inflation on this project emerges in Fig. 9-35, with all (NPV)s corrected to their purchasing power in Year 0. The top line shows (NPV) for various rates of general inflation. The bottom line shows (NPV) for the differential-inflation case in which only the costs are allowed to increase while product selling price and thus cash income remain constant from year to year. The middle hne shows the effect of general inflation when the price rises are delayed by I year. The figure confirms that both of these situations take away from the attractiveness of the project. 

FIG. 9-35 Effect of differential inflation on inflation-corrected net present value. 

The effect upon total taxes paid, when they are corrected to their purchasing power in Year 0, is shown in Fig. 9-36. Differential inflation not only decreases the profitability of the project to its owner but also decreases the revenue received by the taxing authority. The method of calculation is identical to that of the earlier example. 

If the fractional inflation rate is a fractional interest rate on a loan can be corrected to an effective rate of interest by Eq. (9-116) with ii substituted for (DCFRR). The effect of various amounts of loan, borrowed at various interest rates ii, on the net present value of a particular, fairly simple project is shown in Fig. 9-37. Thus, if 25,000 were borrowed at an interest rate of 15 percent for the project, the (NPV) would be about 43,000 at a zero inflation rate. But if the inflation for goods and services i, is 10 percent, the effective interest rate for that loan can be calculated from Eq. (9-116) to be only 4.55 percent. It is seen from Fig. 9-37 that this increases the (NPV) of the project to 48,000. This confirms the economic advantage of borrowing at a fixed interest rate in a time of general inflation. 

A topical aspect of differential inflation is the question of energy costs. Will the cost of a particular fuel rise or fall in relation to prices in general, and if so, what effect will this have on the economics of a project ... 

---