Investment Evaluation Under Conditions Of Inflation
Authors: Davidson L.B. 
Published: December 2007

In today's inflationary economic climate it is important to reconsider carefully investment measures that worked well in the past - they may not work as well today. Explicit inclusion of inflation effects can change the rankings of a set of investments. Proper consideration of inflation also can change investment objectives, and old guidelines should be re-examined.

Introduction

It seems as if death and taxes are adding a third member - inflation - to their club. Double-digit cost increases have been with us for the first time in many years. Moreover, most economic forecasts predict further increases for the next 5 to 10 years, although at a more moderate rate. Current and future government spending plans add plausibility to this scenario of future cost plans add plausibility to this scenario of future cost increases.

This is an economic climate quite different from that of the 1950's and 1960's. Consequently, it is important to reconsider carefully the investment measures that worked well during that period. Are they measures for all seasons or is something new needed? In some cases the answer is clear. For example, future annual cost increases of 10 percent can ruin projects that were selected because they percent can ruin projects that were selected because they exceeded an old discounted cash flow (DCF) return standard of 6 or 8 percent. Clearly, in such cases, the return standard needs some modification. There are good reasons for changing to a return standard that is approximately the sum of the desired real rate of return and the anticipated future annual rate of cost increase. This means discounting at rates on the order of 12 to 16 percent instead of 8 to 10 percent. percent instead of 8 to 10 percent.The problem with most current investment measures is that they measure in terms of money. This would be fine if the buying power of money stayed constant. While such constancy was a fair approximation for the 1950's and 1960's, it is a bad approximation now. In an inflationary climate, the value of a given quantity of money gradually declines. Money in a mattress is worth less each year. Long-payout projects with small percentage returns may not earn enough to repay the money used to start the project, when measured in terms of purchasing power. power.The erosion of buying power can be explicitly accounted for by measuring investment performance in terms of buying power. For example, a measure based on present value of buying power explicitly considers both present value of buying power explicitly considers both the time value and the purchasing value of money. Such a measure sets a low value on money received in the distant future because of the opportunities foregone while waiting for the money and because the future money will not buy as much as it would if available today. With both time value and buying power acting to cheapen future money, the future value is knocked down more than if only the effect of time value were present. In other words, the presence of inflation leads to an increase in the discount rate used to determine present value.

Some would argue that changes in investment standards to account for buying power are not valuable because one cannot accurately predict the future decline in buying power and also because the new standards would not change the preference ranking of investments. The first objection is really more of a lament common to all facets of investment analysis and selection. To make any choice at all, some attempt at soothsaying seems required, or at least desirable. (In fact, some forecast is implied in any investment analysis.)

JPT

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