Qinglei Dai for FEUNL Finanças October 19

Qinglei Dai for FEUNL Topics covered  Inflation in capital budgeting Interest rate and inflation rate Discounting with inflation  Investment with unequal lives

Qinglei Dai for FEUNL Inflation and capital budgeting  Interest rates and inflation The effect of inflation: The time value of money is deflated by inflation. Real interest rate vs. nominal interest rate

Qinglei Dai for FEUNL Inflation and capital budgeting  Approximation The approximation is reasonably accurate when the interest rate and the inflation rate are low. Example. Monarchy of Gerberovia has a norminal interest rate of 300% and inflation rate of 280%.

Qinglei Dai for FEUNL Cash flows and Discount rates  There must be consistency between cash flows and discount rates Real cash flows should be discounted at Norminal cash flows should be discounted at Notice the treatment of depreciations in the two approaches

Qinglei Dai for FEUNL Cash flows and Discount rates: An example year 012 Capital Expenditure1,210 Revenue (real)1, Cash expenses (real) Depreciation (straight line)605 Inflation rate =10% Norminal rate =15.5%

Qinglei Dai for FEUNL Discount with the nominal rate Year 012 Cap. Exp. Revenue Expenses Depreciation Income bf tax Tax Income af tax NCF NPV

Qinglei Dai for FEUNL Discount with the real rate Year 012 Cap. Exp. Revenue Expenses Depreciation Income bf tax Tax Income af tax NCF NPV

Qinglei Dai for FEUNL Investments of unequal lives  So far, the NPV rule has been our rule-of- thumb.  However, there are situations when the NPV rule is not sufficient.  E.g. when investments under decision have different lengths of life.

Qinglei Dai for FEUNL Investments of unequal lives Date Machine01234 A B Discount rate=0.1

Qinglei Dai for FEUNL Investments of unequal lives  The NPV rule does not consider the time that each machine will last.