EBES 2012 Conference – Istanbul, May 24-26, 2012, Istanbul, Turkey

Does Inflation affect Capital Budgeting Decision?

By

Nada Hamed Abdelreheem Ead

Assistant Lecturer
Faculty of Business Administration, Economics and Political Science
British University in Egypt
nadaead@bue.edu.eg

Abstract:
Capital Budgeting decisions are among the most important decisions that investors
make whether these investors are individual or institutional investors. They mainly
focus on the financial evaluation of capital investments (Helen et al). Inflation is a
macroeconomic phenomenon that captures the decrease in purchasing power of a
currency unit over time, due to a general increase in the prices of goods and
services (Beaver & Landsam 1983).
This article measures whether the inflation rate affects the capital budgeting
decisions. These decisions are made using capital budgeting techniques, to choose
among different investment opportunities, and whether these opportunities are
feasible and profitable to the investor or not.

Keywords: Inflation, Capital Budgeting Techniques, NPV, Cash flow, Cost of Capital
JEL classification: B22,B26,G00,G11,G31

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Introduction:
Under the umbrella that the world is a global village, there has been
integration between international trade investment and financial markets
(Subdquist, 2002). More capital mobility are existed, which made investors more
attracted to foreign investments, and they have freedom of choice to decide
between different investments, and they base their decisions mainly on the capital
budgeting techniques that compare between different investment projects, and
there are two steps in the decision process, first the practice of capital investment
involving in it risk, secondly the method of measuring the benefits, weighting the
strategic objectives of the investment against the predetermined risks and in
choosing the method for the analysis is also risky (Elumilade,et-al, 2006,p.141).
That's why each investment project is associated with what is so called "the
risk of owning an asset comes from surprises –unanticipated events. These
unanticipated events are known as risk, there are 2 types of risk, systematic risk
and unsystematic risk"(Ross, et-al. sixth edition: 346). The systematic risk is the
risk that influences a large number of assets and it does have market wide effects,
so it is well known as market risks, while the unsystematic risk is the risk that
affects at most a small number of assets, (Ross, et-al. sixth edition, p.346). These
risks could be project-specific risk, competition risk, industry risk, and
international risk, they could be reduced or minimized through diversification, as
these risks affect a few number of assets (Damodaran, third edition, p. 65-66).On
the contrary the market risk cannot be minimized through diversification, as they
affect most or all of the assets, so this type of risk that the investor is expecting a
reward on (Damodaran, third edition, p. 65-66).
This research paper will focus on the market risk that happens due to
macroeconomic factors that affect all the companies and all the projects. An in
depth focus will be on inflation rate, as the differences in inflation rate will affect
the calculation of the expected return of the project, and this difference is due to,
what so called " the country effect", (Hermes, et-al, p.1). This effect happens due
to different economies associated with the project and, how this will affect the
capital budgeting decisions; this type of risk cannot be diversified as all investment
projects must bear the exposure of this risk. (Damodaran, third edition, p.67)
This research paper is testing whether inflation has an effect on capital
budgeting techniques, where inflation is viewed as the risk associated with any
new investment, and that it should be taken into consideration when making capital
budgeting decisions. Also the research will highlight the impact of the continuous
fluctuation in the inflation rates, due to different economic environment how it
could affect investor decisions.
Capital Budgeting is the process of planning and managing a firm's long
term investments. Investors try to identify investment opportunities that are worth
more to them than the project cost, which means the value of the cash flow

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generated by the project exceeds the cost of this project, the main essence of
capital budgeting decision is to evaluate the size, timing and risk of future cash
flow of the project.
Capital Budgeting techniques are categorized as either sophisticated or
simple,(Axelsson,et-al as cited in Pinches, 1994).These categorization are based on
whether these techniques consider risk and future cash flows in their calculation of
the project, they are referred as sophisticated methods (NPV, IRR, Profitability
Index), while techniques that do not consider risk and future cash flows in their
calculation of the project are referred as simple methods (Payback Period, ARR)
(Gordon & Pinches as cited in Myers,Gordon & Hamer 1984).
Capital budgeting in a developing economy is very vital and must be
approached in a sensitive manner, the rate of economic development in the third
World is almost slow and it needs to be accelerated (Elumilade,et-al,2006, p.137)
that's why the sample will be taken from a developing country (Egypt), in order to
highlight how the developing countries are associated with different factors of risk,
that could affect the decision of investors and managers regarding investments in
these countries.

The relation between Inflation and Capital Budgeting Decision:

Inflation raises important questions of proper measurement; it appears to be
a potential source of errors in measurements by management and even by the
securities markets (Modigliani, et-al, p.1), which will affect the corporate
decisions.
Managers and investors are aware that inflation does exist, but they rarely
relate it in their calculation of the capital budgeting techniques (M.Kannadhasan,
p.2). Finance textbooks are often not clear to show how inflation considerations
should be incorporated in capital budgeting decisions while academic literature is
in general agreement with respect to the principal modifications that inflation
needs to be considered in investment analyses (Modigliani, et-al. p. 1-2). Although
some researchers and textbooks have emphasized not only adoption of sophistical
techniques, but also a correct application of these techniques, adding to that
empirical studies have suggested that the misapplication of these techniques will
lead to inappropriate investment decisions ( Axelsson,et-al 2002 as cited in Drury
& Tayles 1997; Hodder &Riggs 1985,p.21).
An inflationary environment affects both expected cash flows and the cost of
capital (discount rate) (Axelsson, et-al., p.22) and these are the main two items
required in the calculation of the sophisticated techniques and then eventually
decisions are made based on these calculations.
One of the researchers concluded that correct capital budgeting decisions
can be made only when NPV is derived from inflation-adjusted cash flows and
discount rates, any disregarding will result in suboptimal decisions on capital
budgeting, to reach optimal level of capital investment (capital budgeting) will

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depend in general on the rate of inflation, which means that the amount invested
will typically be smaller, the higher the rate of inflation. (Kim Moon, p.941).
As inflation affect cash flows, any distortions caused by inflation derived
from the fact that inflation is not neutral, cash flows are differently affected by
anticipated inflation, which means that real cash flows should be considered, which
is taking into consideration the effect of inflation, so as a result for this, some cash
flows may rise faster, some may rise lower, than inflation and others may stay
unchanged (Axelsson, et-al. 2002, cited in Drury and Taylers ,1997).
As sophisticated techniques deals with future cash flows and discount rate,
so this means that inflation affects discount rate too as it affects the cash flows.
The discount rate is one of the main concepts in finance (M.Kannadhasan, p.9),
based on corporate finance textbooks it is well known as the cost of capital. The
cost of capital means that the cost of financing (Damodaran, 2nd Edition, p.181), it
is the minimum return that investors expected to make when they invest in projects
(M.Kannadhasan, p.9). In order to use the discount rate in NPV, it is necessary to
discount future benefits & costs, this discounting reflects the time value of money,
and the higher the discount rate, the lower the present value of the future cash
flows, and in relating the effect of inflation on discount rate.
Most of the researchers agree that capital budgeting decisions would not be
realistic if the effect of inflation are not correctly factored in the analysis
(M.Kannadhasan, p.5), adding to this inflation need to be considered in a
consistent manner, if consistency is not accounted for the analysis, results will be
biased either as over or underestimation of the profitability of the investment
(Axelsson, et-al. p.22).
In addition the discount rate & the cash flow of the project should be
matched , in terms of nominal cash flow must be matched with nominal discount
rate , while real cash flow must be matched with real discount rate in order to reach
to correct decisions ,and this what many researchers agreed on that the cash flows
& the discount rates must be consistent ,and that future estimates for the free cash
flows have to be made at nominal rates and that they are discounted with nominal
rate of return (Pareja, et-al. p.8)
In order to calculate the NPV, there is a traditional model that is used in
textbooks and by researchers: (Ross, et al, 6th Edition, p.232-233).

NPV = -I +SUM of PV of the cash flows of the project

Where, I is the initial outlay need to invest in the project, and this is paid now (year
0) PV of the cash flows of the project is the present value all the cash flows that
are expected be gained from the project in the future, we cannot compare between
two values at different point in time ,that’s why we get the present value of them.
PV = Sum of CFn / (1+r)n

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Where, CF is the cash flow of each year, r is the discount rate or cost of capital, or
(the required rate of return of the project). n is the period of time .
Most researchers have been using this traditional formula and making
modification to it, in order to consider inflation in their calculation of the NPV. In
M.Kannadahasan's research the main problem that was highlighted that capital
budgeting would be unrealistic if the effects of inflation are not correctly factored
in the analysis, adding to this the researcher focused that inflation influences two
aspects; the cash flow and discount rate, (M.Kannadhasan, p.10).
M.Kannadahasan also focused that the cash flow and discount rate should be
matched, which means nominal discount rate with nominal cash flow or real
discount rate with real cash flow in order to reach accurate results.
The researcher has taken inflation into consideration based on fisher's effect
relationship:

Where r is the discount rate or cost of capital,

K is a combination of real rate
α is the expected inflation rate

M. Kannadahasan research reached that inflation significantly influenced the

capital budgeting decision making process, inflation is a common problem every
financial manager encounters during their capital budgeting decision making
process for optimum utilization of scarce resources especially in cash flow and
discount rate.
Another research by Geofrey T.Mills(p.80-81),who focused on the role of
inflation in capital budgeting, also focused on the interaction between the cost of
capital, inflation and the cash flow variables within a discounted cash flow (DCF)-
Internal rate of return (IRR) frame work. The researcher measured the relation
between inflation and cost of capital in an indirect way, as the research measured
the relation between inflation and movements of interest rates and the relationship
between the rates of interest and cost of capital, it showed the relation according to
the following equations:
Equation 1: i= k+p
Where i is the current stated or nominal rate of interest
k is the real rate of interest
p is the rate of inflation

Equation 2: showed how the previous equation will affect the present value of the
project: PV = C* / (1+i)t

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Where,
PV is the present value C* is the inflated or nominal cash flow, which is C(1+p)t,
this means that inflation is considered in the cash flow i is the nominal rate of
interest that was calculated in equation 1 t is the time period relative to the base
year.
The results of Mills research showed that it is difficult to measure the cost of
capital in a static sense under inflationary expectations and it concluded that it is
reasonable to expect cost of capital will increase at the same rate of inflation on an
ex ante basis and that this increase will be multiplicative relationship.
Another research by Mehta, Curely & Fung (1984:51) discussed the uneven
impact of inflation on the discount rate, the reseachers suggest a logical appropriate
method of incorporating it and they focused that nominal method will be more
accurate in implementing their process. Their research has highlighted the
evaluation of cost of capital, and the influence of inflation on it. They measured the
relation between inflation and cost of capital in terms of the measurement of
CAPM model which is the cost of equity which will be translated into the cost of
capital. In this research they used a new component to the conventional CAPM
model, when adjusting the inflation effect in the model and this model were
suggested by Friend, Landskroner & Losq (FLL)

Where,
E (r) is the expected return on equity rf is the risk free return is the market
price risk is the covariance between the rate of return on the firm's security and
on the market portfolio, which is known as beta A is , where
is the ratio of the nominal value of risky financial assets to the total nominal value
of the sum of risky and riskless financial assets in the financial markets . In their
research they used more modification in the model, according to the modification
that was done by FLL, as follows:

Where,

The recommended modification done by (FLL) to add A and B components

to the CAPM model in order to provide a consistent treatment of inflation in the
capital budgeting procedures. They established an analytical basis for
incorporating inflation into discount rates in a logically consistent way; they
considered some practical aspects of adjustments in the nominal, risk adjusted
discount rate, they started to investigate a problem dealing with the capital

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expenditure decision, and second they assessed the empirical significance of

possible differences in discount rates under alternative methods.
As a result of their analysis they reached that the significance of the
adjustments will depend on the interrelationships among anticipated inflation, the
nominal interest rate and the individual firm's ability to adjust to changes in
inflation as reflected in its profitability.
Adding to this the capital expenditure decision involves the consideration of two
separate but related markets; estimates of cash flows revolve around the goods or
real market, while the discount rate is connected with the financial market.
The speed of adjustment to the inflation expectation change varies in the two
markets, whereby the financial market adjusts much more quickly than the goods
market. Difficulties encountered incorrectly specifying the discount rate is
exacerbated by the absence of a constant, economy-wide real rate on an
inflationary environment.
Another research by Cooley, Roenfeldt & Chew (1979) focused on a certain
area that any increase happens in the general price level for goods and services
necessitate modification of the traditional capital budgeting model by explicitly
incorporating inflation into both the cash flows and discount rates, through a
normative framework building on the traditional NPV model, that should explain
expected inflation and allow for uncertainties in real cash flow, and modifying the
risk adjustment to prevent over adjusting for risk and discounting more certain
flows at a lower discount rate, as follows:

Where:
NPVr is the real net present value (not the traditional net present value)
Co is the initial cash outlay
It is the expected gross cash inflow
Ot is the outflow for variable operating expenses
F is the expected charges fixed for sub periods of the project life
D is the fixed non-cash charges
T is the corporate tax rate
is the percentage change in expected cash inflow(It) induced by inflation in
period j ,
is the percentage change in Ot induced by inflation in period j .
is the anticipated inflation in period j
is the risk premium for the net cash flow resulting from It , Ot & Ft

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According to this modified formula the researchers could calculate the NPV
in more realistic matters ,by taking inflation into consideration , and they
concluded that there is a problem in inflation that it is uncertain and that as the
uncertainties in inflation increase ,there will be higher risk premiums , which will
result that NPVr will be negative and the project will be rejected , although they
added another component to the equation which is the adjustments for the 3
inflationary uncertainties ,these uncertainties are business risk or uncertainty in
operation of the project, uncertainty in the expected inflation rate, and uncertainty
in cash flow sensitivities and general price change, this model covered almost all
the variables that could affect the capital budgeting decision, but this model will
not be used in this research as some of these variables are complicated to get them
on reality.
Another researcher Keith Howe (1992:31) that aimed to reexamine the
inflation adjustment of the discount rate under two competing interest rate
hypothesis; fisher hypothesis which said that an increase in expected inflation
results in an equal increase in the nominal interest rate, leaving the real interest rate
unchanged, if interest rate income is taxed. Darby hypothesis said that an increase
in inflation leads to a greater than proportional rise in the nominal interest rate. The
researcher made also another modification to the conventional method of NPV
which was interpreted as follows:

Where R is the real after corporate tax cost of capital, Ct is the cash flow in period
t, Io is the initial outlay required for the project, in this method there is no
consideration for the effect of inflation, the adjustments made to the conventional
NPV to consider inflation in the method and it is called "nominal approach" that is
presented as follows:

Where, Rn(1+R).(1+ )-1 is the nominal cost of capital

C't is the nomsinal value of cash flows in period t.

The researcher have made a numerical comparison to show the difference between
the two hypotheses and reached a conclusion that response of discount rate to
expect inflation is not sufficiently understood, adding to this that project analysts
would do well to consider carefully the effects of inflation on their discount rate
estimates.
Another researchers John,Ezzell, et-al.(1984) they used adjusted present
value (APV) model to incorporate tax-related capital structure considerations into

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the analysis of the effects of inflation on project values. They made two scenarios
for project analysis, one with zero inflation, the NPV used is the traditional model,
and another time with inflation taken into consideration, so they made modification
to NPV model and reached to the following:

Where K' is appropriate nominal discount factor and C' is the nominal cash flow
adjusted for inflation, and this will introduce NPV' which is the net present value
calculated using nominal cash flows & nominal discount rate.
They have concluded that when leverage matters and when the effects of inflation
are uniform on cash flows, then they have a result that inflation will raise NPVs,
and the discount rate appropriate for valuing real cash flows will fall as the
inflation rate rises.
The research highlighted that according to these results, if the cost of capital
that was appropriate with zero inflation is grossed up by the inflation rate and used
to discount nominal cash flow, this procedure would lead to the rejection of some
projects which would raise the firm's levered value.
Alternatively if projected nominal cash flows during inflation were
converted to real cash flows and discounted by the cost of capital appropriate with
zero inflation, then this procedure also would lead to the rejection of some projects
which would increase the value of the firm.
Another Research by Modigliani & Cohn (1984) discussed the principal
implications of inflation for corporate financial management; their initial concern
is how inflation change standard financial decisions do? They focused on
investment and financial decisions.
One area were in their concern is how inflation affects the net present value model,
adding to this they highlighted that in the presence of inflation ,there should be
distinction between nominal futures net returns( cash flow) and nominal discount
rates (or cost of capital) and that the real flows with the real discount rates, where
nominal future flows are the realized future cash flows, real cash flows are returns
expressed in terms of constant prices or equivalently , deflated by a “general price
index “, also the one period nominal discount factor ( one plus the discount rate)
measures the number of dollars the investors require next period for giving up one
dollar this period, while the real discount factor measures the number of dollars of
current purchasing power that investors demand next period per dollar invested
now. Their conclusion were mainly that capital budgeting analyses are complicated
by inflation because of the following sources of real effects; taxes, debt and other
long-term contracts , that's why they focused on the importance of using either real
approach or nominal approach. Another research by Coulthurst(1986) seek to

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examine that the existence of inflation has on the evaluation of viability of capital
investment projects.
The researcher focused on that when inflation occurs future cash flows will
increase over time, while at the same time the purchasing power of the cash flows
is decreased ,and this is due to the effect of inflation ,also this research ensured that
when evaluating projects under inflation ,cash flows and discount rate must be
measured either in real terms or in money terms (nominal), adding to this the
research has made a conclusion on the misleading decisions that could be made
due to some pitfalls in inflation adjustments , that investors did not make the
comparison based on like with like (nominal or real terms), the use of one general
inflation rate rather than specific escalation factors , and error in forecasting the
effect of inflation.
A final Research by (Webb, 1966), its main purpose is to identify the effect
of inflation through the rate of discount on the investment choice decision.
The intention of the researcher was to analyze whether to use the rate of discount
in times of inflation is realized or whether the occurrence of inflation is causing
some other rate of discount to be used, that means that consideration will be given
to the possible influence of inflation on the rate of discount, and also to evaluate
whether this discount is recognized and properly allowed for. The researcher
introduced a modified formula that consider inflation rate for both cash flow and
discount rate, and highlighting that inflation rate should be different in both.
This is the traditional formula, which is used by all the researchers and is used
in textbooks:

Where,
P.W is the present worth of the project
I is the investment cost of the project
n is the useful life of the project
Bt is the net benefits accruing to that project in each year of its life
r is the appropriate rate of discount in no inflation situation.
While the following formula Webb made modification to the traditional
formula:

Where,
de is the rate of inflation estimated by the investment decision makers.
di is the rate of inflation anticipated by investors

Webb has concluded that in times of inflation market-determined, interest

rate can be expected to contain inflation premiums, and this factor should be

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recognized when making investment choice calculations. The calculation of

inflation premiums present many problems by the sensitivity of many investment
choice calculations to change in the rate of discount used requires that some
attempt to be made to solve them. The premium occurs because the economic
rationality of investors demands that anticipated future inflation be met by the
incorporation into default risk free investment rates of interest of an inflation
premium to meet the anticipated depreciation of the value of money. Based on this
previous research by Webb, the modified NPV formula will be used in this
research as one of the different scenarios to measure the impact of inflation on the
capital budgeting decisions.
From the previous studies that were done on the measuring the relation
between inflation and capital budgeting techniques(NPV method), most of them
concluded that it is essential to use nominal discount rate, which means
considering the effect of inflation, and as doing this nominal cash flow should be
considered, as the constant prices means that inflation is neutral ,and the real prices
does not take inflation into consideration and these wrong consideration could
mislead the investor decisions, but most of them did not reach to an actual relation
between inflation and Capital budgeting techniques they could not interpret the
relation on the real world market, and that the models that were used to show the
relation where very simple in relation to the complexity of the real world, adding to
this that inflation is not a constant rate , it varies from a period to another all
through the life of the project(Cooley Philip,et-al.8) ,Analyst must estimate the
expected inflation rates over the life of the project, (Pareja, et-al. 2002:9), and that
expected inflation is an uncertain parameter in the analysis, so the impact of its
fluctuation should be analyzed(Thams,et-al. 2002:8) in order to minimize the
degree of error in the project evaluation and eventually to minimize error in the
investors decision regarding the project.
Another aspect need to be taken into consideration in this research, that the
“country effect” and how this could affect the decision of investors, and managers,
a more focus will be on the Egyptian Economy and how it is affected after the
revolution .

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A Glance on Egypt Economy:

Egypt's success in implementing sound economic policies, the

accelerating of the privatization process and liberalization of trade are reflected in
the healthy economic indicators that Egypt enjoys (Azab, 2002, p.37). The
following are the main macro level indicators about Egypt, as one of the markets
that investors could invest in it:
Indicator 2007 2008 2009 2010 2011
Population 81,025,000
Real GDP 7.1% 7.2% 4.7% 5.1%
GDP growth rate 7.08% 7.15 % 4.6% 5.14% 1.21%
GNI (LCU) 7.5149 9.0307 1.03948 -
GNI (US $) 1.316 1.641 1.887 -
GNI(growth 6.67% 7.24% 5.386% -
rate)
Cost of Business 28.6% 18.3% 16.1% 16.3%
start up
procedures
(%GNI)
Inflation rate 10.95% 11.70% 16.24% 11.70% 11.06%
Source: Euro Monitor and World Bank and IMF

The fact is that the after 2011 revolution that happened in Egypt the GDP
has declined almost by 4% , the revenues has decreased, due to a great decline in
the level of tourism, which represented a large percentage of the income of the
country . This economic instability is due to the new transitional phase that the
country is in, and this affected the investment of the country, and categorizing
Egypt as a risky economy to invest in, adding to this the rising core inflation index,
the Central Bank of Egypt has to this point decided to maintain the same monetary
policy in place since fiscal 2010.The interest rates remained unchanged for
overnight deposits (8.25 percent) and lending rates (9.75 percent). Private-sector
entrepreneurs have complained about the high cost of loan financing and their
limited ability to secure it. Banks have been reluctant to lend because of the
political and economic uncertainty of the transition, and that in turn could
exacerbate the problem and lead to further deterioration of the economy. This
would place pressure on the transitional government to intervene in the market to
provide alternative sources for funding, which, because of its negative implications
for the budget, would not be a desirable option (Saif, 2011:3). This has affected the
level of investment in Egypt, where Egypt was ranked in Doing Business in 2011
as 108 , and in 2012 after revolution as 110 , adding to this the cost of start a
business as a percentage of income per capita is 5.6, while in Middle East and
North Africa is 35,while in OECD is 4.7.

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In every level required in doing Business in Egypt, it has dropped from 2 to 3 in its
ranking (Source IFC on of World Bank group). Which is due to political instability
which has led to economic risk and eventually higher market risk?

Conclusion:
The capital budgeting is the process of planning and managing a firm’s long
term investments, so it is very important to take a correct investment decisions.
There are two categories in capital budgeting techniques, sophisticated technique
and simple technique.
This paper has based its analysis on the sophisticated techniques, where they take
the future cash flows and risk into consideration, there are different types of risk
associated with any project, and this research has focused on inflation as one of
the main types of risk that affects developing countries nowadays. Inflation means
increase in the general level of prices, an inflationary environment affects both
future cash flows and cost of capital (discount rate), which will affect the decisions
of investors regarding any project.
Correct capital budgeting decision only can be made when NPV (Sophisticated
technique) is derived from inflation adjusted cash flows and discount rate, adding
to this cash flows and discount rates should be matched in terms of nominal cash
flow with nominal discount rate or real cash flow with real discount rate.
According to this, most researchers agreed that NPV is the appropriate tool to be
used as a sophisticated technique that takes into consideration both the expected
cash flows for all the period of the investment and the cost of capital of this
investment, adding to this that all researcher have agreed that inflation need to be
taken into consideration as it affects the capital budgeting decisions. Furthermore
this research can conclude the impact of "country effect" and how it could affect
the decision of investors and managers, which means that in every country there is
a different inflation rate , and this affect the Capital budgeting calculations
regarding new projects, which will eventually ends up that investors and managers
will take different decisions on where is the most appropriate and better country to
make their investment in ,specially that all countries now are considered as one
global village.

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