A common problem, which complicates practical investment decision-making, is inflation. The rule of the game is, as we will emphasize in the discussions that follow, to be consistent in dealing with inflation in cash flows and the discount rate. Inflation is a fact of life all over the world. A double-digit inflation rate is a common feature in developing countries. Because the cash flows of an investment project occur over a long period of time, a business must generally be concerned about the impact of inflation on the profitability of the project. Capital budgeting results will be biased if the impact of inflation is not properly accounted for in the analysis.

Because executives do recognize that inflation exists but they don’t see the need to incorporate inflation into the capital investment analysis. They generally estimate as cash flows assuming unit costs and the current selling price in year zero remain uncollected. They argue that if there is inflation, prices can be raised to cover rising costs; therefore, the impact on the profitability of the projects would be the same if they assume that the inflation rate is zero. This line of argument, while convincing, is fallacious for two reasons.

1. The discount rate used to discount cash flows is generally expressed in nominal terms. It would be inappropriate and inconsistent to use a nominal rate to discount constant cash flows.

2. Sales prices and costs show a different decline in responsiveness to inflation. For certain products, prices may be controlled by the government, or by restrictive competition, or there may be a long-term contract to supply goods or services at a fixed price.

The drug and pharmaceutical industry is an example of controlled and slowly rising prices despite the increase in the general level of prices. Costs are often sensitive to inflation. However, the price of some costs increases faster than others. For example, wages may increase at a higher rate than, say, fuel and power, or even raw materials. There are still examples of certain items that are not affected by inflation. Depreciation tax shelter is not affected by inflation, as depreciation is allowed on the book value of an asset; regardless of their replacement, they are market prices for tax purposes.

• Sunk costs
Sunk costs are expenditures incurred in the past. They are the result of past decisions and cannot be changed by future decisions. Since they do not influence future decisions, they are irrelevant costs. They are unavoidable and unrecoverable historical costs; they should simply be ignored in investment analysis.