How does inflation affect capital budgeting, and how is it handled?

Intermediate

Answer

Inflation affects both cash flows and the discount rate. Consistency is key: either discount money (nominal) cash flows at the nominal (money) rate, or discount real cash flows at the real rate. Mixing them (e.g., real cash flows at a nominal rate) gives wrong NPVs. The Fisher equation links real and nominal rates.

(1 + money rate) = (1 + real rate)(1 + inflation).

Real-world example The team inflates cash flows and discounts at the nominal rate for consistency.

Common follow-ups: What is the consistency rule? | What is the Fisher equation?

Capital Budgeting Cash Budgeting Capital Budgeting

All 34 Capital Budgeting questions