CP

Adjusting for Inflation 311

have been assuming that the project is about as risky as the company’s average proj-

ect. If the project were judged to be riskier than average, it would be necessary to in-

crease the cost of capital, which might cause the NPV to become negative and the

IRR and MIRR to drop below the then-higher WACC. Therefore, we cannot make

a final decision until we evaluate the project’s risk, the topic of a later section.

What three types of cash flows must be considered when evaluating a proposed

project?

Adjusting for Inflation

Inflation is a fact of life in the United States and most other nations, so it must be con-

sidered in any sound capital budgeting analysis.^6

Inflation-Induced Bias

Note thatin the absence of inflation,the real rate, rr, would be equal to the nominal rate,

rn. Moreover, the real and nominal expected net cash flows—RCFtand NCFt—would

also be equal. Remember thatrealinterest rates and cash flows do not include inflation

effects, whilenominal rates and flows do reflect the effects of inflation. In particular, an

inflation premium, IP, is built into all nominal market interest rates.

Suppose the expected rate of inflation is positive, and we expect allof the project’s

cash flows—including those related to depreciation—to rise at the rate i. Further, as-

sume that this same inflation rate, i, is built into the market cost of capital as an infla-

tion premium, IP 
i. In this situation, the nominal net cash flow, NCFt, will increase

annually at the rate of i percent, producing this result:

NCFt
RCFt(1 i)t.

TABLE 8-3 Analysis of a New (Expansion) Project

Part 5

(^6) For some articles on this subject, see Philip L. Cooley, Rodney L. Roenfeldt, and It-Keong Chew, “Capi-
tal Budgeting Procedures under Inflation,” Financial Management, Winter 1975, 18–27; and “Cooley, Roen-
feldt, and Chew vs. Findlay and Frankle,” Financial Management,Autumn 1976, 83–90.

310 Cash Flow Estimation and Risk Analysis