Inflation and Capital Expenditures - Financial Management

During inflationary periods, the level of capital expenditures made by firms tends to decrease. For example, suppose the Apple Manufacturing Company has an investment opportunity that is expected to generate 10 years of cash inflows of $300,000 per year. The net investment is $2,000,000. If the company’s cost of capital is relatively low—say, 7 percent—the net present value is positive:

According to the net present value decision rule, this project is acceptable. Suppose, however, that inflation expectations increase and the overall cost of the firm’s capital rises to say, 10 percent. The net present value of the project then would be negative:

Under these conditions, the project would not be acceptable. The example assumes that expected cash inflows are not affected by inflation.Admittedly, project revenues usually will increase with rising inflation, but so will expenses. As a result, it is somewhat difficult to generalize about net cash inflows. Past experience, however, seems to indicate that cash flow increases often are not sufficient to offset the increased cost of capital. Thus, capital expenditure levels tend to be lower (in real terms) during periods of relatively high inflation than during low inflation times.

Fortunately, it is quite easy to adjust the capital budgeting procedure to take inflationary effects into account. The cost of capital already includes the effects of expected inflation. As the expected future inflation rate increases, the cost of capital also tends to increase. Thus, the financial manager has to estimate future cash flows (revenues and expenses) that reflect the expected inflationary rate.

For example, if prices are expected to increase at a rate of 5 percent per year over the life of a project, the revenue estimates made for the project should reflect this rising price trend.Cost or expense estimates also should be adjusted to reflect anticipated inflationary increases, such as labor wage rate increases and raw material price increases. If these steps are taken, the capital budgeting procedure outlined in this and the preceding chapter will assist the financial manager even in an inflationary environment.


Capital Budgeting

The capital budgeting techniques discussed in this chapter are appropriate for use when evaluating proposed investment projects in both small, or entrepreneurial, and large firms. Conceptually, there is no difference between the value-maximizing capital investment techniques used by large and entrepreneurial firms. In practice, however, there are often significant differences between the capital budgeting procedures used by entrepreneurial firms and larger firms.

As we have seen, larger firms tend to use the net present value and the internal rate of return approaches to evaluate proposed capital expenditures. A study by Runyon of firms with a net worth under $1 million found that nearly 70 percent used payback or another technically incorrect procedure, such as the accounting rate of return, to evaluate capital expenditures. a Several of the firms surveyed reported that they performed no formal analysis of proposed capital expenditures. Several reasons have been advanced to explain the dramatic differences in the practice of capital expenditure analysis between large and entrepreneurial firms.

First, many entrepreneurs may simply lack the expertise needed to implement formal analysis procedures. Or managerial talent may tend to be stretched to its limits in many entrepreneurial firms, such that the managers simply cannot find the time to implement better project evaluation techniques. Also, one must recognize that implementing and maintaining a sophisticated capital budgeting system is expensive. Large fixed costs are associated with putting a formal system in place, and continuing costs are associated with collecting the data necessary for the system to function effectively. In entrepreneurial firms, investment projects tend to be small, and they may not justify the cost of a complete, formal analysis.

The emphasis on the use of payback techniques by entrepreneurial firms may also reflect the critical cash shortages that face many small and rapidly expanding firms. Because of their limited access to the capital markets for additional funds, these firms may be more concerned with the speed of cash generation from a project than with the profitability of the project. Regardless of these impediments to the use of valuemaximizing capital budgeting techniques, entrepreneurs have an excellent opportunity to improve their competitive position by implementing effective managerial control techniques. Entrepreneurs who rely on incorrect techniques, such as payback, to make their project accept –reject decisions are more likely to make poor investment decisions than managers who analyze their investment projects correctly.

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