Capital Budgeting Procedures under Inflation

Abstract

S ignificant increases in the general price level for goods and services necessitate modification of traditional capital budgeting procedures to avoid inefficient allocation of capital. During the 1960's, price levels as measured by the Consumer Price Index increased 2.8% per annum on average and thus far in the 1970's have increased an average of 6.2% per annum. A chronic inflationary environment diminishes the purchasing power of the monetary unit, causing large divergences between nominal and real future cash flows. Thus, since rational decision makers presumably are interested in real returns, they should explicitly include the impact of inflation on investment projects when making capital budgeting decisions. The purpose of this paper is to present a normative framework, building on the traditional net present value model, that explicitly incorporates anticipated inflation and allows for uncertainties in real cash flows. Failure to consider the impact of inflation tends to produce suboptimal decisions for several reasons. For example, cash-flow estimates must embody anticipated inflation if the discount rate contains an element attri-