Chapter 5 • Practical aspects of investment appraisal
As is evident from the above, the tax cash flows can, in the case of investment in cer-
tain non-current assets, lag well behind the cash flow events giving rise to them. It is
important to recognise this time lag, particularly as the cash flows concerned are likely
to be large.5.6 Inflation
Throughout almost the whole of the twentieth century, and continuing into the
twenty-first, the UK has experienced erosion of the purchasing power of the pound.
Much has been written on the causes of and possible cures for it, neither of which falls
within the scope of this book. The effects of inflation, the problem that it causes to cap-
ital investment decision makers, and how they might cope with the problem are our
concern here, however.
Even with relatively low levels of inflation (say, less than 3 per cent), over long peri-
ods prices will be greatly affected. An item costing £100 today would cost £115.93 after
five years if its price increased by 3 per cent each year.
The principal problem facing the decision maker is whether to forecast future cash
flows associated with an investment project in real termsor in money (or nominal)
terms. Real terms here means in terms of today’s (the date of the decision) price
levels; money (or nominal) terms refers to price levels that are forecast to exist at the
date of the future cash flow.
Seeking to forecast in real terms is probably going to be easier because it does not
require any estimation of rates of inflation. Forecasting in money terms is not simply
taking the real-terms forecasts and adjusting for ‘the’ rate of inflation because dif-
ferent types of cash flows will be differently affected by inflation. We tend to view
inflation as operating at one rate across all commodities; this is incorrect. Inflation acts
differentially. An index such as the Retail Price Index (RPI), by which inflation is quite
often assessed, is simply a weighted average of the inflation rates of commodities
bought by a ‘typical’ household. Within that, some commodities may have static or
even declining prices though the average may still be increasing.
Assessing projects in money terms requires forecasts of future price levels for each
element of the decision. In many instances, however, it probably will not materially
affect the issue if prices of all elements are assumed to grow equally. In other cases,
this simplifying assumption may cause unreasonable distortions.
The discount rate will also be affected by inflation. The cost of capital generally
reflects expectations of the general level of inflation rates. Suppliers of finance require
compensation for being prepared to delay consumption. They tend to require addi-
tional compensation where they not only delay consumption by lending, but also
reduce the amount which they can ultimately consume as a result of price rises of
goods and services during the period of the loan.
The relationship between the real and money rates of interest and the inflation rate is1 +rn=(1 +rr)(1 +i)where rnis the money (or nominal) rate of interest (the actual rate of interest payable
by borrowers), rris the real rate of interest (the rate that would be payable if the
inflation rate were zero), and iis the expected rate of inflation in the economy gener-
ally. Where no inflation is expected, rnwill equal rr.‘
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