Inflation is a general rise in commodity prices. Inflation affects traditional profitability measures since such measures ignore the time value of money. Traditional measures are constrained by the fact that initial costs are valued at the historical value while cash flows or benefits are valued at current prices. In periods of inflation, traditional profitability measures will be misleading.
Cash on cash return is given by the ratio of after-tax cash flow and equity investment. It is commonly used in evaluating real estate investments. The ratio gives the amount of money a project generates for every unit of equity invested in the project. In the case of inflation, the value of after-tax cash flows may be high but its purchasing power may be lower than that of equity investment. The same amount of cash flows at the time the investment is made and years after will have different purchasing powers due to differences in inflation rates. If no adjustment is made for inflation, the measure may give the impression that the project is generating more cash flows. Inflation, therefore, overstates the value of cash on cash return.
Payback period gives the time a project takes to generate adequate cash flows to recoup the initial investment in the project. If there is inflation, cash flows generated by the project in future periods will be overstated if they are not adjusted to reflect the real purchasing power. In this case, the investment may seem to have a shorter payback period while in the real sense; the project will take a longer period to generate cash flows with the same purchasing of the initial investment. The same applies to Equity dividend rate as the purchasing power of before-tax cash flows is not the same as that of the initial investment.
In a nutshell, inflation has a great impact on traditional profitability measures. Initial investment is measured at the prevailing inflation rate at the inception of the investment. On the other hand, cash flows are valued at inflation rates in corresponding future periods. Inflation in future years may, therefore, lead to an overstatement of the profitability of a project.
Net present value is the difference between the present value of costs and that of cash inflows generated through the entire life of a project. Internal rate of return is the discount rate that gives an NPV of zero. Net present value assumes that cash inflows from the project are reinvested at the company’s cost of capital while IRR assumes that such cash inflows are ploughed back and reinvested at the project’s internal rate of return. Both methods have inherent limitations making it inappropriate to use a single technique in evaluating projects. The two techniques give the same results when assessing the viability of a single project. However, different results may be found when comparing two or more mutually exclusive projects.
The limitation of IRR is that it ignores the value of the initial cost in the project. For instance, two projects A and B may have internal rates of return of 15% and 10% respectively. Suppose the initial investment in A is $500,000 while that in B is $1,000,000. In this case, IRR method will choose project A over B. This will be a wrong decision as 15% of $500,000 is less than 10% of $1,000,000. In addition, IRR technique gives multiple internal rates of return especially for a project with both positive and negative cash flows during its life.
IRR uses a single discount rate and does not take into account changes in the discount rate, unlike NPV. This makes it inappropriate for evaluating long-term projects in firms whose discount rates are volatile. On the other hand, NPV can use various discount rates.
The major shortcoming of NPV is that it ignores the timing and variability of cash flows. For instance, it is difficult to make choose between two projects with the same NPV but different useful years. A project that generates cash flows over a short period may have a lower NPV than one that generates cash flows over a longer period. In that case, NPV criteria will choose the one with the highest NPV thereby ignoring risk.
In conclusion, both NPV and IRR have inherent shortcomings that should be considered before making a decision. The two techniques give similar results for projects with conventional cash flows. However, for projects with unconventional cash flows, the two give different results. It is, therefore, important for analysts to use both methods to avoid unsound decisions that may arise due to the limitations of the two methods.