How should Inflation be treated in Investment Evaluation?

Inflation is an important parameter in investments, as it erodes the value of money. It must be included in capital budgeting so that cash flows are appropriately included in the evaluation of an investment. In doing so, the inflation targets must be forecasted accurately over a considerably longer duration.

Here are some considerations that must be made while creating inflation in an investment evaluation process.

The forecasts must be spread over a period

Inflation is an ever-existing truth nowadays. Investors face this reality day-in and day-out. They want to gain a return that is more than the inflation rates so that the value of money they invest grows instead of being eaten away by inflation. In other words, investors want to be compensated for inflation apart from getting a return over and above it.

  • It is important to consider inflation while coming up with cash flow estimations. Cash flows occur over a while and sometimes, they may be spread over decades. Therefore, inflation must be treated accurately in the case of cash flow estimations.

  • A little tweak in the inflation measures may have a massive impact on cash flow measures. Therefore, the treatment should be as appropriate as possible to evade the loss of huge amounts of money in the process.

Different components must be forecasted differently

Inflation does not impact all the components of a business equally.

  • For example, some components, such as the salary of employees, the cost of raw materials, and tax rates may go up every year, while sales and profitability may not. Therefore, although it is correct to treat inflation equally over all the components, in practice, doing so will be a blunder.

  • The efficient accountants must therefore treat inflation unequally and match the historical rates to estimate the future inflation rates for each item. Although doing so is tough, it may provide a business with much impetus to grow and avoid the unnecessary inclusion of inflation in the calculation of cash flow.

The Golden Rule

The Golden Rule suggests that accountants must be consistent in the way they treat inflation in the case of cash flows or capital budgeting.

  • If the inflation is treated on real cash flows, the real interest must be used.

  • This is also applicable to nominal rates. When nominal rates of interest are used, a nominal rate of inflation must occur.

The formula for converting real rates to nominal rates and vice versa is,

   (1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)

Although this may seem obvious at the first sight, it is a very common mistake that takes place while calculating the returns in investment evaluation. Having the correct rates that match each other consistently is the Golden Rule to follow.