How do I correctly adjust capital budgeting cash flows for inflation?

Question

AcadiFi · Accepted Answer

The rule is absolute: discount nominal cash flows with a nominal rate, and real cash flows with a real rate. Mixing them produces systematic errors proportional to the inflation rate.

Fisher's equation links them: (1 + nominal) = (1 + real) * (1 + inflation). For a 4% real cost of capital and 2.5% expected inflation, nominal WACC = 1.04 * 1.025 - 1 = 6.66%.

At Brookstone: engineers project real operating cash flows of $3.8M per year for 10 years in today's dollars. To go nominal, multiply each year by (1 + pi_t)^t using an appropriate inflation index. If expected inflation is 2.5% flat, year 5 nominal CF = 3.8M * 1.025^5 = $4.30M. Depreciation tax shields are based on historical-cost book values and must be kept in nominal terms regardless.

Critical subtleties: (1) Different line items face different inflation rates. Labor, materials, and energy may each have their own expected inflation. (2) Revenue pass-through isn't 1-for-1 in most industries; model it explicitly. (3) Working capital investment scales with nominal sales, so inflation inflates the required NWC drag. (4) Depreciation tax shields lose real value under inflation, hurting NPV even when revenues and costs move together.

AcadiFi CFA candidates: if the exam question gives you real cash flows and asks for NPV using a nominal WACC, you must either convert the CFs to nominal or derive the real rate via Fisher. Skipping that conversion is the single most common capital-budgeting error.

How do I correctly adjust capital budgeting cash flows for inflation?

Master Level II with our CFA Course

Related Questions

Practice Questions