Inflation Impacts on Investments
Inflation negatively impacts investments by diminishing their purchasing power and reduce real returns. This deterioration of value can be countered by applying inflation-resistant assets, such as equities or real estate, including the consideration of combined effect of increasing interest rates, which often increase in response to inflation.
Inflation and Investment Appraisal
1. Effect of Inflation on Cash Flows
In business environment, inflation impacts future cash flows will have increasing costs and decreasing purchasing power in current value terms as time elapses. For instance, if inflation is expected to 5% annually and a cash amount of £500,000 is earned at the year-end for 5 years, the values of future cash receipts will be deflated as follows:
Workings (Table 01):
Year 1: Inflation = (1+ 0.05) = 1.05
Inflated Value = 500,000 x 1.05 = £525,000
Year 2: Inflation = (1+ 0.05)^2 = 1.1025
Inflated Value = 500,000 x 1.1025 = £551,250
2. Effect of Deflation on Cash Flows
In a deflationary business environment, there is often a decrease in general price level of goods and services, which has a huge impact on business cash flow, largely resulting from its effects on revenue, costs, debt, and consumer behavior. Deflation increases the purchasing power in current value terms as time elapses.
Workings (Table 02):
Year 1: Deflation = 1/(1+ 0.05) = 1/(1.05) = 0.952
Deflated value = 500,000 x 0.952 = 476,000
Year 2: Deflated = 1/(1+ 0.05)^2 = 0.907
Deflated value = 500,000 x 0.907 = 453,500
3. Nominal Cash Flows
Nominal cash flow is referred to as the actual dollar/pound amount of money a business expects to receive and pay out, without any adjustment for inflation. It shows the face value of the money at the time cash flow happens.
Nominal cash flow is useful for projecting future revenue and expenses, especially in the short term or when is relatively low. Most discounting cash flow (DCF) analyses are computed using nominal cash flows.
Forecast sales volume is 500,000 units per year, rising by 50,000 units per year, and the investment project is expected to last for five years.
Workings (Table 06):
Year 1: Inflated Revenue = Inflated price x Increased Revenue
3,806,500 = 7.613 x 500,000
Year 1: Total Contribution = Inflated Revenue – Inflated Variable Costs
3,806,500 – 2,236,000 = 1,570,500