Topic:
Impact of inflation on capital budgeting in Pakistan.
“Introduction”
In today’s complex business environment, making capital budgeting decisions are among the most important and complicated of all management decisions as it represents major commitments of company’s resources and have serious consequences on the profitability and financial stability of a company. It is important to evaluate the proposals rationally with respect to both the economic feasibility of individual projects and the relative net benefits of alternative and mutually exclusive projects. It has inspired many research scholars and is primarily concerned with sizable investments in long-term assets, with long-term life.
The growing internationalization of business brings stiff competition which requires a proper evaluation and weight age on capital budgeting appraisal issues viz. differing project life cycle, impact of inflation, analysis and allowance for risk. Therefore financial managers must consider these issues carefully when making capital budgeting decisions. Inflation is one of the important parameters that govern the financial issues on capital budgeting decisions.
We want to consider the possible impact of future inflation on Capital Budgeting decisions. Inflation is a rise in prices or fall in the purchasing power on money. Deflation would be a fall in prices, or an increase in the purchasing power of money. However, our concern in Capital Budgeting is future inflation. You will recall from your economics courses, that you can use the price index to turn the nominal prices that we observe in the market into real prices, as if the value of money had not changed.
One of the most important concepts that we need to master is the impact of expected inflation on the required returns we observe in Capital Markets. The fundamental relationship here is the Fisher Effect first formalized by our old friend Irving Fisher in his famous 1900 text (though the roots of the notion can be traced back to the famous philosopher David Hume in the 18th century). Fisher’s fundamental insight is that Capital Market participants are always guessing what future inflation will be and building these guesses of future inflation into the yields on the securities that they buy and sell.
An essential factor of policy continuity and growth of business Investment Company is contributing to the construction or purchase of assets of production and marketing. Realization of investments requires significant funding needs, leading to impairment of long-term. Therefore, the efficiency of investment projects should be compared with the yield on the investment capital. Given the risk embedded, the decision of investment is a bet on the future.
Investment decision is a very difficult for leaders of all firms. By its very nature, the decision affects the investment a company a long time horizon, if not forever.
Managers evaluate the estimated future returns of competing investment alternatives. Some of the alternatives considered may involve more risk than others. For example, one alternative may fairly assure future cash flows, whereas another may have a chance of yielding higher cash flows but may also result in lower returns. It is because, apart from other things, inflation plays a vital role on capital budgeting decisions and is a common fact of life all over the world. Inflation is a common problem faced by every finance manager which complicates the practical investment decision making than others. Most of the managers are concerned about the effects of inflation on the project’s profitability. Though a double digit rate of inflation is a common feature in developing countries, the manager should consider this factor carefully while taking such decisions.
Inflation exists but rarely incorporates inflation in the analysis of capital budgeting, because it is assumed that with inflation, both net revenues and the project cost will rise proportionately, therefore it will not have much impact. However, this is not true; inflation influences two aspects viz. Cash Flow, Discount Rate and hence this study is an attempt to analyses the issues in the area of effects of inflation on capital budgeting decisions for optimum utilization of scarce resources.
Inflation is a monetary aliment in an economy and it has been defined in so many ways, which can be defined as “the change in purchasing power in a currency from period to period relative to some basket of goods and services. When analyzing Capital Budgeting Decisions with inflation, it is required to distinguish between expected and unexpected inflation. The difference between unexpected and expected inflation is of crucial importance as the effects of inflation especially its redistributive effect, depend on whether it is expected or not. Expected inflation refers to the loss the manager anticipates in buying power over time whereas unexpected inflation refers to the difference between actual and expected inflation. If rate of inflation is expected, then the manager take steps to make suitable adjustments in their proposals to avoid the adverse effects which could bring to them.
Ø Problem Statement:
The capital investment decision is not usually well expressed in organizations due to high inflation rate in Pakistan. This is because of capital investment is usually an irreversible decision. Once an organization has committed funds to a project, it must see to the end of the project or else, it might lose all the money initially committed. For example, if a project will cost a certain sum of money and seventy-five percent of this had been committed, for such a project to become operational, the promoter must look for the balance of twenty-five percent or else he will lose the entire sum initially committed. The evaluation of capital budgeting therefore lies in the fact that it assists management in making investment decisions that will provide an adequate cash flow or return to compensate the investors over its investment and also to achieve company’s financial objective of maximizing the wealth of shareholders. The study therefore seeks to examine the importance of capital investment decisions; the basic steps in making capital investment decisions and the techniques used in evaluating capital investment projects so that the overall country’s economy can grow from the corporate sector investments.
Objectives of study:
To analyze the impact of inflation on capital budgeting and explore the factors of capital budgeting which are also being effected by inflation
Source of data
Secondary data Sample selection Questionnaire Articles Internet Secondary data:
The data which we used is valid and include Common sources of secondary data for social science, surveys, organizational records and data collected through qualitative methodologies or qualitative research
Sample selection:
A sample of 70 people is selected to conduct our study regarding impact of inflation on capital budgeting this sample selection makes us enable to analyze the Quantities data collected from questionnaires.
Data collection Methods & Analysis:
We collect data from questionnaires by using sampling techniques in also used some qualitative data to strengthen our results, after collecting data the analysis has done by using SPSS Descriptive statistics, Histogram, scatter plot, correlation and regression. The calculation of the mean, variance and coefficient of variation is a very popular method and relatively easy to use in the evaluation of risk. With the computation of the coefficient of variation and the correlation coefficient, the relative risk of the projects concerned can be compared. The lower the coefficient of variation, the smaller the degree of relative risk. Sensitivity analysis is used in order to improve the accuracy and reliability of cash flows. It requires the examination of the sensitivity of some variable to changes in another variable. The primary purpose of sensitivity analysis is not to quantify risk, but to establish how sensitive the NPV and the IRR are to changes in the values of key variables in the evaluation of investment projects.
“Theoretical Framework”
Theoretical Model
(A thesis on impact of inflation on capital budgeting in Pakistan)
Profitability Index |
Accounting Rate of Return |
Internal Rate of Return |
Net Present Value |
Inflation |
Capital Budgeting |
Variables of Model:
Dependent Variables:
v Capital Budgeting
Independent Variables:
v Net present value
v Internal rate of return
v Accounting rate of return
v Profitability index
“Description of Variables”
Net Present Value:
The net present value of an investment or capital project is the aggregation of the present values of all cash benefits by deducting the present value of all cash Every estimation of NPV of a project should involve measuring the project’s future net cash flows, discounting these at the appropriate cost of capital to procure their present value, deducting the initial capital cost or net investment outlay, at the project commencement period. This expression supports the submission of Porterfield (1966) that the NPV of a project as the present value of cash inflows minus the present value of the cash outflows, Bierman and Smidt (1980) have argued that, the present value of a project should depend on the ratio of interest used, as there is not a single present value estimate but a group of estimates focusing on what rate of interest is selected. In the real world the present value is evaluated, by employing a single, pre-determined interest rate which reflects the view of the firm’s cost of capital. The two most important measures of investment worth are called the discounted cash flow (DCF), measures. It is desirable to explain the concept of the present value of a future sum because in one way or another concept is utilized in both these measures
Internal Rate of Return:
The IRR is a discounting cash flow, which has been enhancing a set of decisions made, based on capital budgeting. It is described as the rate of interest at which the present value of expected capital investment outlays is exactly equivalent to the present value of expected cash earnings on that capital project. It is in essence the rate, which equates the present value of the cash inflows, and also a rate making the computed net present value exactly zero. Separately put, it is the rate of return on invested capital, which the project is returning to the firm, when the net present value is equal to zero.
Many different terms are used to describe the internal rate of return concept. Among these terms are: yield, interest rate of return, rate of return, return on investment, present value return on investment, discounted cash flow, investor’s method, time-adjusted rate of return, and marginal efficiency of capital. IRR and internal rate of return may be used interchangeably. The internal rate of return method utilizes present value concepts. The procedure is to find a rate of discount that will make the present value of the cash proceeds expected from an investment equal to the present value of the cash outlays required by the investment. Such a rate of discount may be found by trial and error. For example, with a conventional investment, if we know the cash proceeds and the cash outlays in each future year, we can start with any rate of discount and find for that rate the present value of the cash proceeds and the present value of the outlays. If the net present value of the cash flows is positive, then using some higher rate of discount would make them equal. By a process of trial and error, an approximately correct rate of discount can be determined. This rate of discount is referred to as the internal rate of return of the investment, or its IRR.
Accounting rate of return:
The accounting rate of return is described as the annual accounting profits from a capital project. The accounting rate of return as a non-discounting criterion is exposed to the same type of criticism like the PB since it violates the two properties of capital flows, but considers all the accounting profits instead of cash flows, over a given life of a capital investment. It however does not consider time value of money. Managers would be indifferent in their choice between one project and other with after tax profits, which may occur in the opposite chronological order because both projects would have similar accounting rate of return. Despite all these flaws accounting rate of return is widely used to appraise capital budgeting decision by financial managers
Profitability Index (PI):
The Profitability Index (PI) also known as the “Benefits-Cost Ratio” is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outlay of the investment. It is another technique at the disposal of an entrepreneurs or decision makers to assist in choosing among several causes of actions.
