Project Evaluation in an Inflationary Environment

This is a case for teaching. This case shows through several examples that the Net Present Value for project evaluation should be calculated based on estimates at current prices. It has been a widespread practice to evaluate projects at constant prices with a great deal of -today- unnecessary oversimplifications. An example is presented were it is shown that the constant price methodology (zero increase in prices of year 0 and real discount rate) is biased upwards and there is a risk that bad projects in the reality be accepted as good projects. Example Setting: Hypothetical firm in an inflationary environment. In this example it is shown how the usual procedure for evaluating a project (i.e., assuming constant prices or constant dollars and a deflated or real rate of discount) could give an inappropriate investment recommendation. Situation: This is a technical note, useful for supporting a lecture, class discussion, or case analysis. The example of a hypothetical firm illustrates how to construct a free cash flow based on given parameters (inflation rate, real interest rate, risk premiums, prices, price increases, elasticity function, accounts receivable and accounts payable policies, etc.) and then value the firm. This technical note has six objectives: * illustrate how to construct a pro-forma financial statement, such as Balance Sheet, Profit and Loss Statement, and cash flow forecast for the new firm. * show how the financial evaluation of the firm as a project made with constant prices and/or constant dollar and real or deflated interest rates might differ from the evaluation of the same project with current or nominal prices. * suggest the conditions or assumptions that have to be met in order for the two approaches (the constant price approach and the current or nominal price approach) to give equal results (this is, identical NPV). * show which problems in the follow up and monitoring of a project might be present when working with the constant price approach. * illustrate why NPV calculated at constant prices and real or deflated rate of interest is, in general, different to the NPV calculated at current or nominal prices and discounted at nominal rates of interest, contrary to what is written in many financial textbooks. * describe how a spreadsheet might be utilized to make a more sophisticated analysis and avoid unnecessary, but widely-used oversimplifications. An Excel spreadsheet accompanies the note and allows students to conduct sensitivity analysis on the project's NPV and other results.