126 Financial Management
which it was accepted, as well as being subject to cost control procedures.Inflation and Capital Budgeting
One of the major mistakes is improper treatment of inflation in capital budgeting decisions.
The capital budgeting results would be unrealistic if the impact of inflation is not correctly
factored in the analysis as the cash flow estimates will not reflect the real purchasing
power. In other words, cash flows would be shown at inflated sums and, to that extent,
cause distortion in capital budgeting decisions. Therefore, cash flows should be adjusted
to accommodate the inflation factor so that the capital budgeting decisions reflect the
'true' picture. This Section dwells on the procedure for adjusting data for inflation.
Consider Example 2.2
An investment proposal P requires an initial capital outlay of Rs. 2,00,000, with no
salvage value, and will be depreciated on a straight line basis for tax purposes. The
earnings before depreciation and taxes (EBDT) during its 5 year life are:Example 2.2
The corporate tax rate is 35 per cent and the company evaluates its investment projects
at 12 per cent cost of capital. Advice the company whether the project should be
accepted. (i) when there is no inflation and (ii) when there is inflation at the rate of 15
per cent per annum, and the stated gross earnings are also expected to grow at this
rate of inflation.
Solution
Determination of NPV (No Inflation situation)
(Amount in rupees thousand)Since the net present value is positive, the project is worth accepting in a non-inflationary
scenario.Year 1 2 3 4 5
EBDT (Rs.) 70,000 76,000 80,000 60,000 52,000Year PBDT Depre-
ciation
(200/5)Taxable
IncomeProfit After
Tax
(Inc.x0.65)Cash Flow
After Tax
(PAT+Dep)PV
FactorPresent
Value1 70 40 30 19.5 59.5 0.893 53.13
2 76 40 36 23.4 63.4 0.797 50.53
3 80 40 40 26.0 66.0 0.712 46.99
4 60 40 20 13.0 53.0 0.636 33.71
5 52 40 12 7.8 47.8 0.567 27.10
211.46
200.00Gross present value
Less: Cash outflows
Net present value 11.46