Project Evaluation under Inflation Condition

Abstract
This paper analyzes the role of inflation in capital budgeting and attempts to
introduce solutions to such implication in order to make the appropriate decision
for the firm’ stockholders under these circumstances.
Inflation leads to biasness in evaluating the investment projects, due to its
impact on the cash flow, the discount rate, the initial investment cost, and the
depreciation. This paper has shown that the capital budgeting process is not neutral
with respect to inflation, as the output prices will raise as well as the operating and
capital expenditures will also be adjusted due to inflation. In addition, it has shown
that it is reasonable to expect that the cost of capital will increase as a result of an
increase in the real interest rate, the inflation premium, and the cost of equity.
Of critical importance is the basis used in calculating the annual depreciation
which may lead to the transfer of wealth from the investment projects to the
government and will result in underestimating the net present value of the
investment projects, if these depreciation charges is calculated based upon the
historical values and not on the replacement cost of the fixed assets.