Investing for inflation is not easy but it must be done or else we are sure to bear the brunt in the long run. A common problem that complicates practical decision making in investment is inflation. The trick is to be consistent when it comes to tackling inflation in discount rates and cash flows. The world over, inflation is a part of life now. Inflation in double digit is a common characteristic in the developing countries. As the cash flows in a project of investment occur over a period of time, a business should be concerned about the impact that inflation will have on the profitability of a project. The results in capital budgeting would be biased in case the force of inflation is incorrectly factored in an analysis. As you can see investing for inflation requires in depth knowledge of how inflation works.
Executives recognize the existence of inflation. However, they do not think it necessary to include it in the capital investment analysis. This makes investing for inflation problematic. They usually estimate the flow of cash assuming costs of unit and the selling price that prevailed in year 0 as uncharged. According to them, if inflation exists, the prices could be increased so that increasing costs are covered. Hence, the impact on the profitability of the project would not change if the inflation rate was assumed as zero. You might find this argument convincing but is actually fallacious. Here are a couple of reasons for this. The rate of discount that is used for discounting the flow of cash is usually expressed in insignificant terms. It is inconsistent and inappropriate to use nominal rates for discounting constant flows of cash. Costs and selling prices show different degrees of responsiveness where inflation is concerned. The prices of certain products are under government control or restrictive competition. There might also exist a contract for the long term to supply services or goods at fixed prices.
World recognized trends forecasters, known by many around the world as the most addictive & highly accurate. Sign up for a FREE Trends alert at: http://www.forecastfortomorrow.com
No comments:
Post a Comment