Corporate finance
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Corporate Finance. Lecture 4. Topics covered. Inflation in capital budgeting Interest rate and inflation rate Discounting with inflation Investment with unequal lives. Inflation and capital budgeting. Interest rates and inflation

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Topics covered
Topics covered

  • Inflation in capital budgeting

    • Interest rate and inflation rate

    • Discounting with inflation

  • Investment with unequal lives


Inflation and capital budgeting
Inflation and capital budgeting

  • Interest rates and inflation

    • The effect of inflation: The time value of money is deflated by inflation.

    • Real interest rate vs. nominal interest rate


Inflation
Inflation

  • Be consistent in how you handle inflation!

    • Use nominal interest rates to discount nominal cash flows.

    • Use real interest rates to discount real cash flows.

    • Notice the treatment of depreciations in the two approaches: Depreciation is a nominal number!


Inflation and capital budgeting1
Inflation and capital budgeting

  • Approximation

    • Real interest rate ≈

      Nominal interest rate – Inflation rate

    • The approximation is reasonably accurate when the interest rate and the inflation rate are low.

    • Example. Monarchy of Gerberovia has a norminal interest rate of 300% and inflation rate of 280%.

      • (1+300%)/(1+280%)-1=5.26%

      • 300%-280%=20%


Inflation1
Inflation

Example

You own a lease that will cost you $8,000 this year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?


Inflation2
Inflation

Example - nominal figures


Inflation3
Inflation

Example - real figures


Cash flows and discount rates an example
Cash flows and Discount rates: An example

Inflation rate =10%

Norminal rate =15.5%







Discount with the real rate5
Discount with the real rate

(1+15.5%)/(1+1.10)-1=5%

Real rate=












Investments of unequal lives
Investments of unequal lives

  • So far, the NPV rule has been our rule-of-thumb.

  • However, there are situations when the NPV rule is not sufficient.

  • E.g. when investments under decision have different lengths of life.


Investments of unequal lives1
Investments of unequal lives

Discount rate=0.1







Investments of unequal lives7
Investments of unequal lives

NPV rule will suggest Machine A because it has a lower NPV of costs……But, is this correct?


Investments of unequal lives8
Investments of unequal lives

  • The NPV rule does not consider the time that each machine will last.

    • Machine A is cheaper but only last for three years.

    • Machine B is more costly but last for one more year.

  • Therefore, it is necessary to compare the cost on a per year basis.



Investments of unequal lives10
Investments of unequal lives

  • Annuity

  • A: 798.42=C1*

    C1=798/2.4869=321.05

    B: 916.99=C2*

    C2=916.99/3.1699=289.28

    C1>C2, it is cheaper to buy machine B