In the first paper it was shown that inflation worsens the
profitability of an investment when the present value method is
used. This was due to a continuously increasing need for nominal
working capital. The present value sensitivity of a working capital
investment was very strong in reaction to inflation, the percentage
change of the present value being -((1 + i)/i) 100 s, where i refers to
the real discount rate and s to the rate of inflation. The change in the
present value is linearly dependent on the rate of inflation.
Using the annuity methods as the method of investment appraisal,
inflation raises the annual capital costs (annuity) by the amount of
-s(1 + i) W, where W refers to the real amount of the working
capital. The rise of the capital costs is thus the product of the rate of
inflation and the working capital investment in year 0 multiplied by
the real discount factor. It was also shown that a profitable
investment under non-inflation becomes nonprofitable due to
inflation if the rate of inflation is higher than a certain critical rate of
inflation (sī).
Using the IRR as the method of investment appraisal the working
capital was considered only on payment basis. Inflation decreased the
real IRR. Thus as inflation increases the real profitability of the
investment worsens.
Using the payback method the working capital was considered only
on payment basis, because the payback period measures the financial
effects of the investment. As the non-interest payback period is
shorter than the service life of the investment, the payback period
under inflation can be solved either by using the equation n* = (C +
W)/(P - sW) (in real terms) or S(n*,s) = (C + W)/((1 + s)P - sW) (in
money terms), where n* refers to the payback period (non-interest),
C to the amount of investment in fixed assets, P to uniform annual
net returns, s to the rate of inflation, W to the real working capital
and S(n*,s) to the prolongation factor for uniform annual payments.
The product of sW can also be interpreted as the real value of
nominal annual increase in working capital. If the investment is
totally financed by debt, the payback period can be solved by the first
mentioned equation. It presupposes that amortizations and interest
on debt are not affected by inflation. In that case inflation shorters
the pay back period. If the latter equation is applied, inflation
lenghtens the pay back period. Correspondingly the interest bearing
payback period n*(i) can be solved by the equation a(n*(i),i) = (C +
W)/(P - (1 + i)sW). In this case inflation lenghtens the interest
bearing pay back period.
(The Finnish Journal of Business Economics 4-1982, 398-428)