Impact of Inflation on a Project

 Impact of Inflation on a Project

Forecasting of future inflation is a difficult task and therefore, it is a risk for a Project.  However, in order to minimize this risk, the project analyst has to estimate the probable rate of inflation during the project life and identify its effects on project variables. Failure to do so would mainly exert two types of risk on a project, i.e.; liquidity and solvency risk.

 

Liquidity risk

When a project cannot meet its commitments in time it faces liquidity problems.  As a result of inflation, the costs of a project would increase and the project may not be able to meet its commitments in time and at the lowest cost. Consequently, its activities would not work as scheduled. For example, investment cost may go up with the inflation as discussed earlier and financing would be a problem in the short run or it may have to be done at a higher cost. Thus its activities cannot be implemented as expected.

 

Solvency risk

When the liquidity problems continues different problems would crop up. When the project cannot be implemented smoothly it may loose the market. The project may loose the confidence of the parties involved with it, as the project fails to meet its commitments. When the cost increases unexpectedly, forecasted costs of the project would increase and profitability will come down. These consequences ultimately affect the performances and profits targets of the project. Thus, the project may end up with negative net worth revealing its inability to meet even its outside liabilities (insolvent).

 

Accounting for Inflation

When project variables are valued at constant prices the analysis is earlier, but it ignores the effects of real changes in prices as well as inflationary effects. As these effects are Dot taken into consideration the analysis would give a misleading picture of a project. Therefore it is a necessary factor that price changes are included in the financial analysis. For this purpose, all the variables should be valued to effect the expected price changes in the economy and in a consistent manner. Then they could be suitably discounted to reflect the real value and present values. The steps required could be outlined as below.

a) Estimate expected changes in relative prices during the life of the project considering the demand and supply forces governing the variables considered.

b) Estimate the general level of inflation expected to be during the life of the project considering the other macro economic factors such as GDP growth, government policies and external environment.

 

c) Combination of above two factors provide an estimation for the changes in future prices or the changes in nominal prices and all the input and output variables should be valued at a price incorporating the above changes. (Price changes may not be same for all variables).

 

d) Use the above value of inputs and outputs to construct the Cash flow Statement.

 

e) Determine the nominal interest rate taking the price changes at ‘c' above into consideration.

 

f) Construct profit and loss accounts for the life of the project taking the nominal values and determine the tax liability of the project to be incorporated in the Cash Flow Statement. Depreciation, Stocks and Interest Expenses should be considered as discussed earlier.

 

g) Estimate the Cash requirements of the project and changes in the cash stock to be incorporated in the Cash Flow Statement.

 

h) Determine the financing requirements along with the repayment of principle and interest to be included in the cash flow taking the inflation into consideration.

 

I) Once you follow the above steps you complete the construction of Cash Flow Statement in terms of nominal prices. The next task is to bring the nominal net cash flow into real values. This can be done by deflating the nominal net cash flows by the price index (inflation).

j) Discount the real net cash flow using an appropriate discount rate.

 

The development of a cash flow as above allows you to incorporate inflation into the financial analysis so that they would reflect real picture of its performance. As the financial analysis provide a realistic picture of the project, the decision-makers are better informed and in a position to take more accurate decisions.