Question

We are studying Project Cash Flows and Capital Budgeting and I need help with the below?

What are some ways a company might mitigate inflation risk?

Answer 1

Inflation risk:

Inflation in general will impact the cash flows projected and used under capital budgeting analysis. But inflation will also have a similar impact on the hurdle rate used in the capital budgeting decision.

Measures to mitigate inflation risk

Please note that inflation, interest rate, exchange rate risks etc are systemic risk and hence can't be eliminated fully. By very definition, they are non diversifiable, unpredictable and hence uncontrollable.

However, certain measures and precaution can help us mitigate the inflation risk to some extent. They are presented below:

1. When conducting a capital budgeting analysis, we need to make sure that inflation is treated the same in both the hurdle rate and the cash flow estimates. There are two ways to reflect the effect of inflation in capital budgeting analysis:
   1. We consider real cash flows and then discount them using real hurdle rate. So, inflation adjusted cash flows are discounted by inflation free discount rate. If the cash flows do not include the impact of inflation, then the inflation rate should be deducted from the discount rate.
   2. We consider nominal cash flows and we discount them using nominal hurdle rate. A nominal hurdle rate will include inflation premium. Lenders and equity investors will include this to ensure that they are compensated for a loss of purchasing power caused by inflation. It makes sense then that the cash flows should reflect the additional cash flow increases caused by inflation. If the discount rate includes an inflation premium (as it almost always will), then the cash flows should reflect the inflation rate also. In other words, the actual cash flows (after the impact of inflation) should be used.
2. Inflation, interest rate and exchange rates are circular variables. One impacts the other two and at the same time get impacted by the other two. Thus hedging against interest rate risks and exchange rate risks in a way leads to a hedge against inflation also.
3. Hedge against inflation: Future contracts and forward trades in future can act as hedge against inflation.