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A Note on Biases in Capital Budgeting Introduced by Inflation

Published online by Cambridge University Press:  19 October 2009

James C. Van Horne
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Extract

In the allocation of capital to investment projects, it is unlikely that optimal decisions will be reached unless anticipated inflation is embodied in the cash-flow estimates. Often, there is a tendency to assume that price levels remain unchanged throughout the life of the project. Frequently this assumption is imposed unknowingly; future cash flows are estimated simply on the basis of existing prices. However, a bias arises in that the cost-of-capital rate used as the acceptance criterion embodies an element attributable to anticipated inflation, while the cash-flow estimates do not. Although this bias may not be serious when there is modest inflation, it may become quite important in periods of high anticipated inflation. The purpose of this note is to investigate the nature of the bias and how it arises.

Type
Communications
Information
Journal of Financial and Quantitative Analysis , Volume 6 , Issue 1 , January 1971 , pp. 653 - 658
Copyright
Copyright © School of Business Administration, University of Washington 1971

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References

1 See Fisher, Irving, The Theory of Interest (New York: The MacMillan Company, 1930), Chapter 2, from which most of the work on yields and inflation stems.Google Scholar

2 See Bronfenbrenner, Martin and Holzman, Franklyn D., “Survey of Inflation Theory,” American Economic Review, LIII (September 1963), pp. 597–599.Google Scholar

3 We assume that no call feature exists on the instrument and that investors pay no taxes on dividends and capital gains.

4 In one study, Mundell, Robert, “Inflation and Real Interest,” Journal of Political Economy, LXXI (June 1963), pp. 280–283CrossRefGoogle Scholar, contends that nominal rates of interest may contain less than the full rate of anticipated inflation. The reason is that inflation may influence wealth variables in such a manner as to lower the real rate of interest.

5 Again, it is important to stress that we have assumed that the acceptance of the project does not alter the risk complexion of the firm as a whole.

6 For further analysis of this point, see Motley, Brian, “Inflation and Common Stock Values: Comment,” Journal of Finance, XXIV (June 1969), pp. 530–535.CrossRefGoogle Scholar

7 Brofenbrenner, and Holzman, , “Inflation Theory,” pp. 647–649Google Scholar; Kessel, R. A. and Alchian, A. A., “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices,” American Economic Review, L (March 1960), pp. 43–66Google Scholar; Bach, G. L. and Ando, Albert, “The Redistributional Effects of Inflation,” Review of Economics and Statistics, XXXIX (February 1957), pp. 1–13Google Scholar; and Cargill, Thomas F., “An Empirical Investigation of the Wage-Lag Hypothesis,” American Economic Review, LIX (December 1969), pp. 806–816.Google Scholar

8 For the logic behind this statement, see Van Home, James C., Financial Management and Policy (Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1968), p. 130.Google Scholar

9 See Cagan, Phillip, “The Monetary Dynamics of Hyperinflation,” in Friedman, Milton, ed., Studies in the Quantity Theory of Money (Chicago: University of Chicago Press, 1956), pp. 23–117Google Scholar; and Gibson, William E., “Price-Expectations Effects on Interest Rates,” Journal of Finance, XXV (March 1970), pp. 19–34.CrossRefGoogle Scholar

10 Again, we have assumed that selection of the project will not affect the risk complexion of the firm as a whole.

11 If expected cash flows are expressed as a probability tree reflecting series of conditional probabilities over time, each possible future cash flow should embody an assumption with respect to the rate of future inflation. This rate should be treated as stochastic. The project then could be evaluated according to the expected value of net-present value and the standard deviation of the probability distribution of possible net-present values, where the risk-free rate is used as the discount factor. This risk-return approach can be extended to handle the marginal impact of a project on the expected value and standard deviation of the probability distribution of net-present values for the firm as a whole. See Van Home, James C., “The Analysis of Uncertainty Resolution in Capital Budgeting for New Products,” Management Science, 15 (April 1969), pp. 376–382.CrossRefGoogle Scholar