NPV with Inflation

When appraising capital projects, basic techniques such as ROCE and Payback could be used. Alternatively, companies could use discounted cash flow techniques such as Net Present Value (NPV) and Internal Rate of Return (IRR). This page looks at how to take account of inflation when using NPV techniques.

Inflation

Inflation is a general increase in prices leading to a general decline in the real value of money.

Impact of inflation on interest rates.

In times of inflation, the fund providers will require a return made up of two elements:

• real return for the use of their funds (i.e. the return they would want if there were no inflation in the economy)
• additional return to compensate for inflation.

The overall required return is called the money or nominal rate of return.

The real and money (nominal) returns are linked by the formula:

(1 + i) = (1 + r)(1 + h)

where

i = money rate

r = real rate

h = inflation

Impact of inflation on cash flows

Where cash flows have not been increased for expected inflation they are known as current cash flows, or real cash flows.

 Where cash flows have been increased to take account of expected inflation they are known as money cash flows, or nominal cash flows. Remember, if they do take inflation into account, they represent expected flows of money, hence the term 'money cash flows'.

Specific and general inflation rates

Discounting

The impact of inflation can be dealt with in two different ways - both methods give the same NPV.

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