Modeling the Impacts of Inflation in Investment Appraisal

Unquestionably, before the advent of the personal computer, modeling the impacts of inflation in investment appraisal was an enormous task. Currently, with the widespread availability of personal computers, conducting investment appraisal by constructing financial statements with nominal prices is a straightforward and simple task. In this paper, we would like to persuade the reader (if indeed there is need for persuasion) that conducting investment appraisal based on financial statements with real prices is potentially misleading and under certain circumstances, the adverse effects of inflation could result in the selection of 'bad' projects. The paper is organized as follows. In Section One, we discuss some of the apparent reasons why the real prices approach persists in investment appraisal. In Section Two, we review briefly some of the main impacts of inflation and use simple numerical examples to illustrate the ideas. In Section Three, we combine all of the previous examples into a single numerical example and use sensitivity and scenario analyses to examine the impacts of inflation on the NPV of the project. First, we conduct a simple sensitivity analysis of the NPV of the project with the expected inflation rate. Second, we conduct a detailed sensitivity analysis of the PV of each line item in the FCF statement and identify the specific effects of inflation. We show clearly why the results from the real prices approach are incorrect and explain the reasons for the inadequacy of the real prices method. Note that the sensitivity analysis is unrealistic because it assumes that the same inflation rate will occur for all the years. In Section Four, we redo the analysis with different scenarios for the expected inflation rates. Scenario analysis is extremely flexible. For example, for one scenario, we can specify that the expected inflation rate is 8% for two years and 10% for the next three years.