When a business entertains the thought of undertaking a large project such as constructing a new building or acquiring a large amount of expensive equipment, it will assemble financial information to test whether the project will ultimately make more money than it costs. A well-planned and executed capital budget that accounts for inflation is the tool that helps companies make this type of decision.
The preparation of a capital budget gives business users an estimate of the potential rates of return from investments they make in long-term assets. Performing financial analysis provides justification for a business project or acquisition with a high-dollar investment requirement. If the company could gain more appreciation on its capital by investing in stocks or other financial instruments rather than taking on a capital project, it would probably choose to do so.
Real Cost of Capital
Inflation affects capital budgeting in a significant way. It makes up a part of the market rate of return, and capital budgets reveal the true project cost when using the real rate of return, rather than the market rate. Calculating the real rate of return begins with the market rate of return, then subtracting inflation. This is sometimes stated as its inverse, the real cost of capital.
Inflation affects capital budgeting analyses since the market cost of capital is not completely representative of the real cost of borrowing funds. However, performing the analysis in a manner that compensates for inflation removes its impact from the results of the capital budget.
Inflation impacts can be removed from a capital budgeting analysis by calculating the real rate of return and using it in the capital budgeting cash flow calculations. When formulating a capital budgeting scenario with the real rate of return, the answer has been adjusted for inflation. Conversely, if the rate of return is not adjusted, the cash flows can be adjusted for inflation to match the inflation that is "built in" to the market rate of return. In either scenario, it is important to make sure the cash flows and rate of return are on the same basis, either with or without inflation.
Inflation can be an especially difficult problem for businesses in developing countries, since in some countries it can exceed 100 percent per year. As the rate of inflation increases, investors require a higher real rate of return to compensate, which makes many projects very expensive.
Inflation affects the outcome of capital budgeting in other ways besides the rate of return. Generally, inflation drives up costs for goods and services, including building materials, equipment and labor. These increased costs might render certain projects unfeasible based on the results of the capital budget analysis.