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FINANCIAL MANAGEMENT DEVELOPMENT Decision Making Capital Expenditure NO 337 DEALING WITH INFLATION IN INVESTMENT APPRAISAL I v v FINANCLAL MANAGEMENT DEVELOPMENT ONE OF A SERIES OF GUIDES FOR FINANCIAL MANAGEMENT DEVELOPMENT FROM wwwFinancialManagementDevelopmentcom This is one of a series of documents produced by David A Palmer as a guide for managers on specific financial topics to assist informed discussion Readers should take appropriate advice before acting upon any of the issues raised Financial Management Development DAP 337 Page 2 of 5 DEALING WITH INFLATION IN INVESTMENT APPRAISAL The Problem Sophisticated investment appraisal uses Discounted Cash ow techniques to help make decisions about whether a particular capital investment is worthwhile Does it have a positive Net Present Value at the Corporate Cost of Capital and to assist the ranking of investment proposals when capital is in short supply Which projects have the better Internal Rates of Return These analyses and the less sophisticated use of Payback and Discounted Payback rely on the correct identification of cash ows and their allocation into the appropriate time periods in the future However problems arise with the fact that some cash ows may be in quotmoney of the dayquot and some may be in quottoday39s termsquot In addition many organisations require the analysis to be carried out in today39s terms in order to calculate the quotReal Returnquot Whether the data available is in current or future terms is a matter of fact What is important is that the analysis should contain data which is all on the same basis and that the discount rate used should be consistent with the type of data Including sales figures at future prices and costs at today39s prices is a good way of getting your proposal accepted but will not necessarily lead to the correct decisions The Solutions There are two potential solutions 1 A11 cash ows at today39s prices and a discount rate excluding in ation or 2 A11 cash ows at the prices prevailing in the relevant future year and a discount rate which includes an allowance for in ation It does not matter which method is used the Discounted Payback NPV and IR will be the same Problems only arise where the base data is inconsistent and the methods to bring consistency to the data are set out below for each of the two approaches wwwFinancialManagementDevelopmentcom David A Palmer 2000 Financial Management Development DAP 337 Page 3 of 5 Option 1 Today39s Price The majority of income and costs will be available at today39s prices from the accounting records These need no adjustment Certain future Incomes and Costs are at fixed prices 6 g Rent of 10000 per year Other Incomes and Cost may be expressed in future prices eg we will sell 100 units per year but our prices will be 100 in Year 1 and 110 in Year 2 To bring either of these to today39s prices they need to be de ated Usually this is best done by accumulating all the Incomes and Costs in future prices and then de ating them by the General Rate of In ation Alternatively this can be done line by line with the calculation carried out before entering the data Thus if in ation were 5 the Year 1 Sales Income would be de ated by 1 divided by 105 ie 10000 X 1 divided by 105 9524 and for Year 2 Income would be 11000 X 1 divided by 105 X 105 9977 Once the Income and Costs have been expressed in today39s terms then the Discount Rate Used should exclude in ation This gives a Real Internal Rate of Return The actual Rate of Return including in ation would be higher than that shown in the calculation by approximately the rate of in ation Option 2 Future Prices The words quotCurrent Pricesquot should be avoided because they could mean today39s or future prices If all Incomes and Costs are at future prices then the discount rate should include in ation Any costs which are at today39s prices need to be increased to re ect the likely future prices which will be paid This is best done separately for each major cost head as some eg rent raw materials costs fuel etc may not rise with the RPI Note Consistency is Vital and the best way to ensure consistency is to state the Basis All costs are at Today39s Prices or All costs are at Future Prices and How the data has been adjusted to achieve it wwwFinancialManagementDevelopmentcom David A Palmer 2000 Financial Management Development DAP 337 Page 4 of 5 wwwFinancialManagementDevelopmentcom David A Palmer 2000 Financial Management Development DAP 337 Page 5 of 5 DAVID A PALMER BA Financial Control FCA ATII MCIPD David is an experienced financial professional who has devoted his skills to management training in practical understanding and utilisation of financial information A Graduate Chartered Accountant and Associate of the Institute of Taxation he is also a Member of the Chartered Institute of Personnel and Development He has worked as a Financial Controller and Company Secretary in the Finance Industry and as a Director of Finance and Administration in the Computer Services industry Since 1990 he has conducted management development programmes for over thirty major organisations including Blue Circle BP CSC Computer Sciences Conoco Ernst amp Young Lloyds Bowmaker The Post Office Rothmans and Zeneca International training experience includes work in Denmark Kenya and the Czech Republic for Unilever in Dubai for A1 Atheer in Holland and the US for Avecia and Zeneca and in Bahrain and Saudi Arabia for Cable amp Wireless He specialises in programmes in financial management for both tactical and strategic decision making A key output from the training is demonstrable use of the knowledge and skills acquired to enhance corporate profitability In addition he has run courses in acquisition evaluation The Economist Blue Circle and Hays Chemicals and in post acquisition management Unilever He has also developed material for delivery by in house personnel Royal Mail Lloyds Bowmaker and Conoco and computer based training packages The Post Office Unilever and BP He is a prolific writer of case studies role plays and course material he has also published articles on the financial justification of training financial evaluation of IT investment proposals the use of Activity Based Costing and Customer Profitability statements commercial considerations for consultants and the need for taxation awareness training for general managers He is married with one grown up daughter and his outside interests include being The Treasurer of the Hospice of St Francis Berkhamsted and a member of the Catholic Alpha Training Team Promoting the Alpha course on Basic Christianity He was a Governor of Luton University for nine years and a school Governor for four years This series of papers is designed to help managers by providing a basic understanding of key financial concepts to assist them in their work It is provided at no cost since this knowledge is a Gift from God and thus to be shared Matthew 108 wwwFinancialManagementDevelopmentcom David A Palmer 2000