CHAPTER 6 AN INTEGRATED APPROACH TO FINANCIAL ANALYSIS

TABLE OF CONTENTS INTRODUCTION NOMINAL, REAL PRICES AND INFLATION MARKET AND REAL EXCHANGE RATES INFLATION AND NOMINAL INTEREST RATE IMPACTS OF INFLATION –5.1 DIRECT IMPACTS –5.2 TAX IMPACTS

INTRODUCTION Projects which are feasible in the absence of inflation could turn out to be unfeasible with inflation. Countries have inflation at varying levels. Inflation effects the outcome of the project through direct impacts (on investments, A/R, A/P, cash held, interest expenses) and tax impacts (interest expenses deductions, depreciation expenses and inventories and cost of goods sold). In this chapter we will see how inflation effects the outcome of a project and how we could integrate it into our model in order to capture its effects.

2. NOMINAL, REAL PRICES AND INFLATIONS 1.Nominal Prices (Current prices) P 1 t,P 2 t, P 3 t ……….. P n t 2.Price Level P L t =  i n (P i t W i ) Where: i = Individual good or service included in the market basket P i t = Price of the good or service i at a point in time W i = Weight given to the price of a particular good or service (i); where  w i = 1 Note: it is generally useful to express the price level of a basket of goods and services at a specific point in time in terms of a price index (P ) P t I = P t L / P B L Where P t L = Price level in period (t) P B L = Price level for the base period (B)

2.NOMINAL, REAL PRICES AND INFLATIONS (Cont’d) 3.Changes in Price Level (Inflation) Measured in terms of a price index: g P = ((P I t - P I t-1 )/(P I t-1 )) * Real Prices P t JR = P t J / P t I Where P = nominal price of good or service as of a point in time P = Price level index at time period (t) 5.Changes in Real Prices Change in P t JR = (P t JR – P t-1 JR ) / P t-1 JR Where P t JR denotes the real price of goods (j) as of a specific period

Example 1: Nominal Prices and Changes in Price level Assume Year 1 is base year Goods 123 Weights Nominal Prices Year 1:P 1 1 =30 P 2 1 =100 P 3 1 =50 P L 1 =0.2(30)+0.5(100)+0.3 (50) P L 1 =71 P L B= 71 Price Index P I 1 =1.00 Nominal Prices Year 2:P 1 2 =40 P 2 2 =110 P 3 2 =40 P L 2 =0.2(40)+0.5(110)+0.3(40)= P L 2 =75 P L B= 71 Price Index P I 2 =1.056

Example 1: Nominal Prices and Changes in Price Level (cont’d) Assume Year 1 is base year Goods123 Weights Nominal Prices Year 3:P 1 3 =35 P 2 3 =108 P 3 3 =60 P L 3 =0.2(35)+0.5(108)+0.3 (60) P L 3 =79 Price Index P I 3 =1.113 gP I 2 = ((P I 2 - P I 1 )/(P I 1 )) * 100=(( )/1.00))*100= 5.63% gP I 3 = ((P I 3 - P I 2 )/(P I 2 )) * 100=(( )/1.056)*100= 5.33%

Real Prices and Changes in Real Prices EXAMPLE 2:Real Prices and Changes in Real Prices Goods123 Weights Nominal Prices Year 1:P 1 1 =30 P 2 1 =100 P 3 1 =50 Price Index P I 1 =1 Real Prices Year 1: P 1R 1 =30/1 P 2R 1 =100/1 P 3R 1 =50/1 P 1R 1 =30 P 2R 1 =100 P 3R 1 = Nominal Prices Year 2:P 1 2 =40 P 2 2 =110 P 3 2 =40 Price Index P I 2 =1.056 Real Prices Year 2: P 1R 2 =40/1.056 P 2R 2 =110/1.056 P 3R 2 =40/1.056 P 1R 2 =37.87 P 2R 2 = P 3R 2 =37.87

EXAMPLE 2:Real Prices and Changes in Real Prices (Cont’d) Goods123 Weights Nominal Prices Year 3: P 1 3 =35 P 2 3 =108 P 3 3 =60 Price Index P I 3 =1.113 Real Prices Year 3: P 1R 3 =35/1.113 P 2R 3 =108/1.113 P 3R 3 =60/1.113 P 1R 3 =31.46 P 2R 3 =97.06 P 3R 3 =53.92 Changes in Real Prices Year 2 Change in P iR 2 = P iR 2 - P iR 1 / (P iR 1 ) = (( )/30)=0.26 ( ( )/100)=0.04 (( )/50) Changes in Real Prices in Year 3 Change in P 1R 3 = P 1R 3 - P 1R 2 / (P 1R 2 )= (( )/37.87) (( )/104.13) (( )/37.87) = = =0.42

2.NOMINAL, REAL PRICES AND INFLATION (Cont’d) 6. Inflation Adjusted Values  P j t+1 = P j t ( 1 + gP t jR ) (1 + gP I e ) Where:  P j t+1 = denotes the estimated nominal price of good (j) in year t+1; P j t = denotes the nominal price of good (j) in year t ; gP t jR = denotes the estimated growth in real price of good (j); P I e = denotes the assumed growth in price level index from year t to year t+1 7. Constant Prices Fixed set of prices at given year t 0 P t t+n = P i to ; P k t+n =P k to Note: It simplifies the construction of Cash flow statements but ignores financial and economic information that can affect the future performance of the project.

3. MARKET AND REAL EXCHANGE RATES The market exchange rate is the current price of foreign exchange. The market rate between the domestic currency and the foreign currency can be expressed at a point in time (t) as: E = (#D/F) t If the price index for the domestic currency’s economy is I D at the time t, and the price index for the foreign currency’s country is I F, then the real exchange rate (E R ) at that point in time can be expressed as: E t R = (#D/F) t * (I t F / I t D ) E t R = E t M * (I t F / I t D )  E t M = E t R * (I t D / I t F )

4. INFLATION AND NOMINAL INTEREST RATES Nominal Interest Rate = (i) Real Interest Rate = (r) Risk Premium = R Expected Growth (inflation) in Prices = gPe Given the factors above, nominal interest rate is calculated as: i = r + R + (1 + R + r) gPe

Example By using following information Inflation rate( gPe ) = 20% Risk Premium ( R ) = 0 Real Interest Rate (r) = 0.05 i = r + R + (1 + R + r) gPe i = ( )* 0.20 i = 0.26

5.IMPACTS OF INFLATION 5.1Direct Impacts of Inflation (i)Impact on Financial Investment a. Costs could increase due to increases in price levels. This is normal and the model captures this. It is part of the financing plan. b. Over-run costs are unplanned increases in costs which could be due to delay in finishing the project or unexpected increase in the cost of inputs. c. Inflation will effect the nominal value of the investment financing but it will not effect the cash flow in real values.

Table 6-1 Project XYZ Financing Period01 Inflation = 0% 1. Price Index Investment Outlays Inflation = 25% 3. Price Index Investment Outlays Impact on Financing Real Inv. Outlays (4/3) *Inflation will not effect the real value of investment expenditure

(ii)Impact on Interest and Principal Payments i = r + R + (1+R+r) g P e At r = 5% and g P e =20%  i = 26% Comparing two cases Case 1: $1000 5% Interest, No inflation Case 2: $1000 5% Interest (26% in nominal rate) In real values for both cases there is no difference in the amount of payment for interest and principal. In real values Case 2 (inflation) pays higher installments (interest payments) and a lower principal at the end of the project compared to Case 1. Case 2 can fall into the liquidity trap during the project years, while Case 1 may not be able to pay the principal in the final year.

Table 6-2 Inflation and Its Effect on Interest and Principal Payments Price Index 1. $1000 Interest & No Inflation Loan Interest Loan Payment Cash Flow in Year 0 Prices Net Present Value (Equilibrium Situation) Price Index 2. $ % Interest & 20% Inflation Loan Interest Loan Payment Cash Flow in Current Prices Cash Flow in year 0 Prices Net Present Value (Dis-Equilibrium Situation) 3. Undiscounted Change in Cash Flow =Case 1 - Case 2 in Year 0 Prices Period Real Cash Flow Case 1 (No inflation) Case 2 (Inflation)

(iii)Impact on Desired Cash Balances Inflation results in a loss in the purchasing power of the cash hold. When there is an inflation, sales receipts, expenditures increase in nominal prices even if the amount of goods sold does not change. Increase in inflation increases the desired cash balances both in nominal and real values thus the cost of the project increases. Inflation has an adverse effect on the outcome of the project through increasing the amount of desired cash holdings.

Inflation and Desired Cash Balances Case A: (With Zero Inflation) Assumptions Zero Inflation Desired cash = 10% of Annual Sales Real rate of discount = 5% Real PV of Holding Cash = /(1+.05)4 = Year Sales Desired Cash Cash Flow Impact

Inflation and Desired Cash Balances (Cont’d) Case B: (With 20% inflation) Assumptions 20% Inflation Desired cash = 10% of Sales Real rate of discount = 5% % = With inflation rate of 20% the cost of cash balances have increased 4.33 times Year Price Index Sales Desired Cash Cash Flow Impact Real Cash Flow

(iv)Impact on Accounts Receivable Increase in inflation will increase the sales and accounts receivable in nominal prices. Through inflation accounts receivables will increase in real terms as well. This will have a negative effect on the net cash flow of the project. Inflation has a negative effect on the outcome of the project through increasing the amount of accounts receivables in real terms.

(iv)Impact on Accounts Receivable (Cont’d) Likewise inflation has a positive effect on the project through accounts payable, as the payment in real values decreases. When inflation rises, buyers will try to postpone payments (increase accounts payable), while the sellers will try to shorten the period of payments of their customers (reduce the accounts receivables).

Impact of Inflation on Accounts Receivable and Accounts Payable Case A: (With Zero Inflation) Assumptions Zero Inflation Acts Receivable = 50% of Sales Year Sales Acts Receivable Change /AR Receipts

Impact of Inflation on Accounts Receivable and Accounts Payable Case B: (With 20% inflation) Assumptions 20% Inflation Acts Receivable = 50% of Sales Year Price Index Sales Acts Receivable Change /AR Receipts A. Real Receipts if 20% inflation B. Real Receipts if zero inflation Difference (A-B)

5.2Tax Impacts of Inflation i)Impact through Tax Deductıon of Interest Payment Interest payments are deducted from the taxable income, while the principal payment is not. As you would recall, inflation increases the interest payments in real values during the project life, while reducing the amount of principal to be paid in the final year (5.1(ii)). Increase in inflation has a positive effect on the outcome of the project through increasing the annual interest payment and reducing the taxable income and thus reducing the tax to be paid to the government.

Tax Impacts of Inflation Tax Deduction of Interest Expense Tax shelter of interest expense because it is a deduction from taxable income Case A: If 5% interest rate, $1000 loan, and zero inflation then Year Interest Expense A: If tc = 40%, Tax savings Case B: If 20% inflation, 26.0% interest, $1000 loan then: Year Nominal Interest Expense Real Interest Expense B: If tc = 40%, Tax Savings Increased Tax Shelter (B-A)

(ii) Impact through Depreciation Expense and Taxes Depreciation allowances are deductible from the taxable income. When inflation rises, the depreciation allowance in real values decreases and this increases the taxable income. Thus tax payment to the government increases. Increase in inflation has a negative effect on the outcome of the project through reducing the depreciation allowance.

Inflation Depreciation Expense and Taxes Investment of $1000 in year zero, depreciated over 4 years, depreciation expense is deductible from taxable income Year Depreciation Tax Savings if tc =.40 A: If zero inflation, real value of tax savings Price Index if 20% inflation B: If 20% inflation then real value of savings Real difference in tax savings (A-B)

(iii) Impact through Inventories and Goods Sold FIFO (First In First Out): Price of old inventory (input) is used to calculate the cost of goods sold. LIFO (Last In First Out): Price of last input is used. An increases in inflation increases the amount of tax to be paid through both approaches (FIFO and LIFO). In FIFO, the additional tax to be paid is spread out through the project life. In LIFO, the additional tax to be paid accumulates to the final year of the project. This is very risky.

Inflation, Inventories and Cost of Good Sold Two ways of accounting for cost of goods sold: (1) FIFO(2) LIFO 1. FIFO: If Zero Inflation Year A. Sales of Output B. Purchases of Input C. COGS D. Measured Profits (A-C) E. Taxes Paid if tc =.40 If 20% Inflation Price index a. Sales b. Purchases of Input c. COGS d. Measured Profits e. Nominal Taxes Paid if tc =.40 f. If Real Taxes Paid Difference f-E Note: Additional tax liability is distributed evenly.

Inflation, Inventories and Cost of Good Sold 2. LIFO: If Zero Inflation Year A. Sales of Output B. Purchases of Input C. COGS D. Measured Profits (A-C) E. Taxes Paid if tc =.40 If 20% Inflation(Price index) a. Sales b. Purchases of Input c. COGS d. Measured Profits e. Nominal Taxes Paid if tc =.40 f. If Real Taxes Paid Difference f-E Note: Additional tax liability accumulated in the final year.