Corporate Finance

Free Cash Flow Valuation 
 189

The Impact of Inflation on NPV

In chapter 2, we learnt about the concept of real and nominal rates of return which are linked by the equation:

( 1 + k) = ( 1 + i) ( 1 + r)

where

k= nominal rate,

i= inflation, and

r= real rate expressed in decimal form.

It is evident from the above equation that the nominal discount rate used in calculating NPV would go up
if the inflation rate increases. The increase in the discount rate would lead to a lower NPV.
An example is in order. An investment has the following cash flows:

Year Cash flows (Rs)

0 –1,000

1 200

2 300

3 400

4 400

The firm uses a discount rate of 10 percent, which includes an expected inflation of 4 percent.

So the real rate:

r= [(1 + k)/(1 + i)] – 1

= (1.10/1.04) – 1

= 5.76 percent

NPV of the project using a discount rate of 10 percent is –1000 + [1003.48] = 3.5

Suppose the expected inflation was 8 percent. Then the nominal rate would be:

(1 + k) = (1.08) (1. 0576)

k= 14.22 percent

The NPV decreases due to an increase in discount rate.

REAL VERSUS NOMINAL CASH FLOWS

Cash flows can be stated either in nominal terms or in real terms. If cash flows incorporate expected inflation
they are said to be nominal. Nominal cash flows can be adjusted for inflation and stated in real terms. The
relationship between nominal and real cash flows is:

Real cash flow = Nominal cash flow * [Price index in next period/Price index this year]

An investment is expected to return Rs 100 the next year and the price level is expected to increase by
4 percent during the period.