Question

a)   Explain the role of inflation in cash flows. Focus specifically on the impact of inflation on the cash flows of a project investment.

b)   Discuss the impact of taxation and the impact of inflation in the calculation of the cost of capital.

Answer 1

Solution:

a) Inflation in general plays a negative role in cash flows management i.e. due to rising inflation the cash depreciates in value more rapidly and cash looses its value. Lets talk about the same in case of a project.

Lets suppose a project is due to generate cash inflows in 1, 2, 3 , 4 years respectively and inflation is also rising and so will be the nominal rates (real + Inflation) as a result of which our discounting factor which we would use to discount the future cash flows would also increase thus decreasing the net cash flows. -> PV of cash flows = Cash flow in a year / Discounting factor

b) For the calculation of the cost of capital WACC model is used which uses a combination of Preferred stock , Equity and debt to calculate the cost of capital.

WACC = Wd Kd (1-t) + We Ke + Wp Kp

Where Wd, We, Wp are the weights of the preferred stock , equity as well as debt.

Kd -> gross cost of debt

t -> tax rate

Ke -> cost of equity

Kp -> cost of preferred stock

With an increase in taxation the net cost of debt decreases i.e Kd(1-t) as t increases 1- t decreases , but it does not have any impact on the cost of equity and cost of preferred stock. Increase or change in inflation effects all the three as for Kd the nominal rates comes into picture and forms the base for the risk free rate , for Ke we use CAPM (ke = rf + beta(rm - rf)) as rf increases the net ke increase depending upon beta and market return.

For preferred stock = Dividend Per share/ Discount rate.

As the inflation change the discount rate changes and hence the cost of preferred stock . As inflation increases Kp decreases and vice versa.

So inflation has a direct impact on equity i.e. ke increases with rise in inflation , Kp as a negative relation with inflation i.e. with rise in inflation kp decreases and Kd also have a negative relation with inflation.