Inflation and capital budgeting are closely related and at no cost capital budgeting can be completed without taking into account inflation. All of us know, that inflation causes our purchasing power to decline. So, if we buy an asset for USD5000 today, it is probable that the same asset can be bought for USD10,000 after a couple of years. However, it is assumed that the project cost as well as net revenues increase in a proportionate manner with inflation. For this reason, in reality rates of inflation are not taken into account. But this is not true always, inflation does affect capital budgeting. Inflation and capital budgeting are bound to affect cash flows .
Inflation affects discount rates and cash flows. There are two factors on which inflation acts. They are discount rate and cash flow.
Let us assume that r refers to the revenues; t refers to the tax rate; c is the cost and d is the depreciation. By arranging the above variables in a formula the following is obtained.
(r-c) (1-t) + d = (r-c) (1-t) + dt
Inflation affects (r-c) (1-t), which is on the right side of the equation. But Inflation does not impact dt. The reason can be attributed to the fact that historical costs determine depreciation costs. This implies that inflation has a tendency to decrease the value of real rate of return. Studies reveal that Net cash flow is more as compared to real cash flows provided we do not take inflation into account.
Discount rates refer to the rate of return, which is the required rate or the target rate. The project cost is inflation adjusted. This adjustment is usually done in the premiums. The required rate or the target rate of return for the investors ought to be the same as real inflation return together with the expected inflation rate.