Transcript Finance I - Universidade Nova de Lisboa

Finanças
October 19
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Topics covered

Inflation in capital budgeting



Interest rate and inflation rate
Discounting with inflation
Investment with unequal lives
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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
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Inflation and capital budgeting

Approximation


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%.
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Cash flows and Discount rates

There must be consistency between cash
flows and discount rates

Real cash flows should be discounted at

Norminal cash flows should be discounted at

Notice the treatment of depreciations in the
two approaches
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Cash flows and Discount rates:
An example
year
0
1
2
Revenue (real)
1,900
2000
Cash expenses (real)
950
1000
Depreciation (straight line)
605
605
Capital Expenditure
Inflation rate =10%
Norminal rate =15.5%
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1,210
Discount with the nominal rate
Year
0
Cap. Exp.
Revenue
Expenses
Depreciation
Income bf tax
Tax
Income af tax
NCF
NPV
NPV
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1
2
Discount with the real rate
Year
0
Cap. Exp.
Revenue
Expenses
Depreciation
Income bf tax
Tax
Income af tax
NCF
NPV
NPV
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1
2
Investments of unequal lives
So far, the NPV rule has been our rule-ofthumb.
 However, there are situations when the
NPV rule is not sufficient.
 E.g. when investments under decision
have different lengths of life.

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Investments of unequal lives
Date
Machine
0
1
2
3
A
-500
-120
-120
-120
B
-600
-100
-100
-100
Discount rate=0.1
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4
-100
Investments of unequal lives

The NPV rule does not consider the time
that each machine will last.
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