Methods of Inflation Adjustment
There are two main methods of adjusting cash flows for inflation: the nominal cash flow method and the real cash flow method.
- Nominal Cash Flow Method
The nominal cash flow method involves using the actual cash flows without adjusting them for inflation. This method is suitable when the cash flows are expected to increase at the same rate as inflation. However, it may not provide an accurate representation of the true profitability of the investment if the cash flows do not align with the inflation rate.
To calculate the nominal cash flows, simply use the actual cash flows projected for each period without any adjustment for inflation.
- Real Cash Flow Method
The real cash flow method involves adjusting the cash flows for inflation to obtain the real value of the cash flows. This method is more accurate as it takes into account the impact of inflation on the purchasing power of money.
To calculate the real cash flows, the following steps can be followed:
- Identify the inflation rate for each period. This can be obtained from historical data or economic forecasts.
- Apply the inflation rate to each cash flow to adjust it for inflation. The formula for adjusting cash flows for inflation is as follows:
Real Cash Flow = Nominal Cash Flow / (1 + Inflation Rate)
For example, let’s consider a cash flow of £10,000 in Year 1 with an inflation rate of 3%. The real cash flow would be calculated as follows:
Real Cash Flow = £10,000 / (1 + 0.03) = £9,708.74
Repeat this calculation for each cash flow in each period to obtain the real cash flows.
Importance of Inflation Adjustment
Adjusting cash flows for inflation is important for several reasons:
- Accurate Decision-Making: Inflation can distort the true profitability of an investment. By adjusting cash flows for inflation, decision-makers can make more informed and accurate investment decisions.
- Comparability: Adjusting cash flows for inflation allows for better comparison between investment options with different cash flow patterns.
- Real Value Assessment: The real cash flows obtained through inflation adjustment provide a more realistic assessment of the purchasing power of the investment returns.
Conclusion
Inflation adjustment is a crucial step in investment appraisal to ensure accurate and reliable results. The nominal cash flow method and the real cash flow method are two commonly used techniques for adjusting cash flows for inflation. The real cash flow method is generally more accurate as it considers the impact of inflation on the purchasing power of money. By adjusting cash flows for inflation, decision-makers can make informed investment decisions and assess the true profitability of investments.