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Adjustment for Inflation in Capital Budgeting

Adjustment for Inflation in Capital Budgeting

Adjustment for Inflation in Capital Budgeting : Capital Budgeting means budgeting for capital expenditure. It refers to “making a large outlay of money today in anticipation of benefits (also known as Cash inflows) which would come across the life of the investments”.Prices don’t stay stagnant; they change. While taking capital budgeting decision we should take cognizance of inflation. This is because inflation will raise the revenues and costs of the project. Therefore we should carefully compute future cash flows and discount rate. Adjustment for inflation in Capital Budgeting is essential.

Adjustment for Inflation in Capital Budgeting : CASH FLOWS

The future cash flows can be expressed either inclusive or exclusive of inflation. While the cash flows includes future inflation they are called as money cash flows. When they exclude inflation they are referred as real cash flows.

For example: You find that the next year’s price of Rs. 22,000 is on account of 10% inflation.

Here, Rs. 22,000 is the actual amount payable and it is money cash flow. If there had been no inflation the cash flow would have been 22,000/1.1= 20,000. This is the real cash flow.

DISCOUNT RATES:

Discount rates can be expressed at inclusive of future inflation or exclusive of future inflation. When discount rates includes future inflation they are called as money discount rates and when they exclude inflation they are referred as real discount rates.

It is very important that if cash flow considers inflation then discount rate should also include. If cash flows exclude inflation, the discount rate should also exclude inflation.

The link between the money discount rate, real discount rate and inflation rate is:

MDR= [(1+RDR)(1+IR)]-1

Where, MDR= Money Discount Rate

               RDR= Real Discount Rate

               IR=     Inflation Rate.

PRESENT VALUE

Money cash flows should be discounted at money discount rate to arrive at present value. Similarly real cash flows should be discounted at real discount rate to arrive at present value.

It is very important to note that in computing Net present value also known as NPV all cash flows should be expressed either in money terms or real terms. This means that if cash inflows are in real terms, cash outflows also should be expressed in real terms.

Rules for conversion are:

  1. Money cash flow can be converted to real cash flow by discounted at inflation rate.
  2. Real cash flow can be converted to money cash flow by compounding at inflation rate.

Note: Depreciation is a non cash charge. But it relevant for capital budgeting decision because it effects tax. Depreciation is on original cost. Hence we should consider it as an zero inflation.

Therefore we can conclude that:

  1. Adjustment for inflation in capital budgeting is very essential.
  2. Depreciation are based on historical costs. Tax benefits accruing from depreciation should not be in parity with inflation.
  3. If cash includes inflation, then discount rate should also include. Similarly, if cash flows exclude inflation then discount rate should also exclude.
  4. If cash inflows are in money terms, cash outflows should also be expressed in money terms. If cash inflows are in real terms, then cash outflows should also be expressed in real terms.

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