Inflation, Cost of Capital, and Capital Budgeting Procedures

Abstract

Efforts to incorporate a volatile inflationary environment in capital expenditure analysis have typically led to a prescription such as "Discount nominal cash flows by nominal rates and real flows by real rates."' While this statement is logically consistent and intuitively appealing, it glosses over thorny conceptual issues in devising implementation procedures for capital budgeting decisions. In particular, this paper contends that the discount rate estimate, whether in nominal or real terms, is not a simple task when inflation is expected to undergo changes.