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Inflation and its impact on investment decisions in the hospitality industry
Inflation and its impact on investment decisions in the hospitality industry Ray H. Anderson
Footscray Institute of Technology, Victoria 3011, Australia
The impact of inflation is more severe in the hospitality industry than in some others because of its high level of capital investment. Proper evaluation of investment returns can only be made if inflation is considered in the evaluation process. This article presents an approach based on the net present value method of investment evaluation which incorporates the anticipated level of inflation and provides for the uncertainties of future cash flows.
investment Key words: net present value
hospitality industry
introduction
cash flow
The net present value method stated as follows:
A recent feature of the Australian economy and those of other countries has been significant increases in the general level of prices of goods and services. Whilst such an inflationary environment affects all industries, its impact is more severe on the hospitality industry because of the high level of capital investment in buildings, fittings and equipment. Furthermore, as inflation will affect the returns obtained by firms operating in the hospitality industry, proper evaluation of investment opportunities will only occur if inflation is explicitly considered in the evaluation process.
l
t=f
where
NW
= the net present value of the proposal, = the estimated net cash flow each year for the proposal, = firm’s cost of capital, = life of the proposal, = investment outlay of the proposal.
NCF, k N 1,
The calculation of the net present value is shown in Example 1 for the following investment proposal: Example 1 Snack Foods Ltd. is considering investing $200,~0 in a piece of equipment which will be used to manufacture ‘Cheesies’, a new health food. The expected life of the equipment is four years and based on market research and cost estimates it is anticipated that the project will generate the following cash revenue and costs:
Net present value Finance literature has long demonstrated that the discounted cash flow method of net present value is superior to other methods of evaluation used for making capital investment decisions. Under this method the cash flows generated by an investment proposal are discounted using a firm’s cost of capital as the discount rate. Only the proposals whose discounted cash flows have a positive net present value shall in theory be undertaken by the firm. Vol. 2 No. 3 pp. 121-125
can be formally
NW=: (l+k)N -NCF, _ ()
The purpose of this article is to present an approach based on the net present value method of investment evaluation which incorporates the anticipated level of inflation and provide for uncertainties in future cash flows. By use of numerical illustrations it will be shown that failure to consider inflation may lead to erroneous investment decision making by management.
Int. J. Hospitality Management Printed in Great Britain
evaluation
inflation
121
Year
Revenue ($1
costs ($1
1 2 3 4
140,000 140,000 140,000 140,000
60,000 60,000 60,000 60,000
027%4319/83 $3.00 + 0.00 Pergamon Press Ltd
Ray H. Anderson
122
All cash flows are assumed each year.
to
occur at the end of
The only other expense will be that of depreciation which will be calculated on a straight-line basis over the life of the proposal. The proposal is expected to have no salvage value at the end of its life and the company pays tax at the rate of 46%. The company’s cost of capital is 10%. The discount factors for each year at 10%~ are set out in Appendix A. As Example 1 shows, the net present value method discounts future cash flows since it recognises that these flows have a lower present value than amounts received today (because these latter amounts can be invested and earn interest). The rate of interest considered relevant for discounting purposes is the minimum required rate of return (cost of capital). As the net present value is positive the proposal should be accepted. However, the presence of inflation requires that adjustment be made to the above model since the failure to allow for inflation may result in companies making incorrect capital investment decisions. Adjusting the net present value method for inflation - The net present value method can be adjusted to allow for inflation in either of two ways:
(9
(ii)
Calculate net present value by stating all future cash flows in terms of the dollars expected to occur and discount them at the minimum required rate of return (cost of capital) adjusted for inflation. OR Calculate net present value by stating all cash flows in real terms, that is, present day values and discount them at the minimum required rate of return (cost of capital) expressed in real terms.
Both methods.
Example
if correctly
applied,
will result
the same net present value. However, the first method has the advantages that it is easier to understand, better reflects what management is doing in practice and is more consistent with the information used for post-appraisal of investment decisions. Adjustment of cash flow and discount rate - From Example 1 it can be seen that the major components of the net present value method are the cash flows and the discount rate selected. The net cash flows will be affected by inflation since revenue, through increases in selling prices, and labour and other costs will increase. Depreciation expense will not be affected since it remains constant in amount once the asset is acquired. The discount rate used for discounting the cash flows is the cost of capital. This rate is determined by weighting the cost of finance provided by lenders and equity investors of the firm. Since lenders and investors will require a rate of return which will include an allowance for future inflation it is necessary to adjust the cost of capital for this factor. The inflation adjusted cost of capital is determined using the following formula: K = (1 + k) (1 + fI)-
1
where K = firm’s inflation adjusted cost of capital, k = firm’s cost of capital excluding any adjustment for inflation, n = expected annual rate of inflation. Using the earlier example, the cost of capital is 10% and if expected inflation over the next four years is 5%. the firm’s inflation adjusted cost of capital is 15.5% calculated as follows: K = (1 + 0.10) = 1.1551
(1 + 0.05) - 1
= 0.155 or 15.5%‘.
in
1
Year
(1) Revenue
(2) costs
1 2 3 4
140,000 140,000 140,000 140,000
60,000 60,000 60,000 60,000
(3) Depreciation
50,000 50,000 50,000 50,000
(4) Profit before tax
(5) Tax 46%
(6) Profit after tax
(7) Net cash flow (6)&(3)
(8) 10% factor
(9) Present value
30,000 30,000 30,000 30,000
13,800 13,800 13,800 13,800
16,200 16,200 16,200 16,200
66,200 66,200 66,200 66,200
0.909 0.826 0.751 0.683
60,176 54,681 49,716 45,215 209,788
Less outlay Net present
200,000 value
$9,788
inflation andimpacton
123
investmentdecisionsin hospitality management
discounts these flows using the inflation-adjusted cost of capital. It is assumed that inflation occurs evenly throughout the year in respect of cash flows.
discount rate to apply for The appropriate discounting purposes in this situation would be 15.5%. Example 2 calculates the net present value of the investment proposal using the inflation adjusted cost of capital as the discount rate whilst holding cash flows constant on the assumption that they are not affected by inflation. The net present value is negative and indicates that the proposal should be rejected. This is the opposite conclusion to the previous example where inflation was ignored in the analysis. This example shows that where the discount rate reflects inflationary expectations the failure to adjust cash flows for the level of expected inflation will bias the evaluation process and can lead to erroneous investment decisions.
Example 3 In order to ascertain the net cash flow for each year the revenue and cost amounts must be adjusted by the expected inflation rate to determine their future value. The factors used to determine these cash flows are set out in Appendix A. The proposal with inflation taken into account in the cash flows and the cash flows discounted at the inflation-adjusted cost of capital, now has a positive net present value. As noted by Van Horne (1971) the failure to adjust cash flows for the level of expected inflation when using a cost of
Example 3 adjusts net cash flows for the expected level of inflation of 5% per annum, and
Example 2
Year
ii, Revenue
_~ 1 2 3 4
._________.~ (31 Depreciation
(2) costs
..-
(4 Profit before tax
(5) Tax
(6) Profit after tax
30,000 30,000 30,oCIo 30,000
13,800 13,800 13,800 13,800
16,200 16,200 16,200 16,200
60,000 60,000 60,000 60,000
140,000 140,000 140,000 140,000
50,000 50,000 50,000 50,000
(7) Net cash flow KW(3)
03) 15.5% factor
(9) Present value
66,200 66,200 66,200 66,200
0.866 0.750 0.650 0.562
57,329 49,650 43,030 37,204 187,213 200,000
Lessoutlay Netpresentvalue
$(12,787)
Example 3 _-~I__.-... Year
Revenue ~....~-._-.-.-
1 2 3 4
Year
1 2 3 4
140,000 x 140,000 x 140,000 x 140,000 x -
(1) Revenue
147,000 154,280 162,120 170,240
1.05 = 147,000 1.102 = 154,280 1.158 = 162,120 4.216 = 170,240 -_________--
~ cost ---. ~__________~
60,000 x 60,000 x 60,000 x 60,000 x
1.05 = 1.102 = 1.158 = 1.216 =
(2) costs
____I__(3) Depreciation
(4) Profit before tax
(5) Tax 46%
63,000 66,120 69,480 72,960
50,000 50,000 50,000 50,000
34,000 38,160 42,640 47,280
15,640 17,554 19,614 21,749
63,000 66,120 69,480 72,960
(7) Net cash flow
(8) 15.5% factor
(9) Present value
68,360 70,606 73,026 75,531
0.866 0.750 0.650 0.562
59,200 52,955 47,467 42,448
(6) Profit after tax -__18.360 20,606 23,026 25,531
202,070 Lessoutlay Netpresentvalue
200,000 $2,070
Ray H. Anderson
124
capital which incorporates inflation will lead to a bias in the evaluation of investment proposals and may lead to erroneous decisions on the part of a firm’s decision makers.
The proposal would be rejected on the basis of the above quantitative analysis although qualitative factors may ultimately determine the final decision. Summary
and conclusion
The previous example has assumed that the rate of inflation will affect revenue, costs and the required return of lenders and investors by the same amount. However, it is likely that the effect of future inflation on the required rate of return will differ from that on the projected cash flows. Furthermore, the items comprising the cash flow may individually be affected differently by the anticipated level of inflation. Example 4 is based on an in~ation-adjusted required rate of return of 15% with revenue and costs subject to an inflation rate of 5% and 8% respectively.
In recent years significant increase in the general level of prices of goods and services has been experienced in Australia and other countries. The impact of such an inflationary environment will be severe on the hospitality industry due to its high level of capital investment. The article has therefore outlined an approach to incorporating inflation into the investment evaluation process enabling management to avoid erroneous decision making.
The net present value for the proposal is now negative following the incorporation of a higher cost inflation rate than that applicable to revenue.
Van Horne, budgeting
Example
Reference James C. (1971) A note on biases in capital induced by inflation. .Jo~~~rcl qj’ Firrmce wzd ~~~u?z~~f~t~~,~J Anffi~.~i.s653-658.
4
Year
Cost
Revenue
1
140,000
x 1.05
= 147,000
60,000
x 1.08
: 4
140,000 140,000
162,120 x 1.102 1.158 = 154,280 x 1.216 = 170,240
60,000 60,000
x 11.260 .I 68 = 70,080 75,600 x 1.360 = 81,600
__.~
---
..~_~
_..
= 64,800
.._ _
Year
~~
(I)
Revenue
~___
(2)
Costs
~_
(3) Depreciation
__..
.____.
(4) Profit before tax -...
:
154,280 147,000
70,080 64,800
50,000
34,200 32,200
3 4
162,120 170,240
75,600 81,600
50,000 50,000
36,520 38,640
(5)
Tax 46%
(6) Profit after tax
14,812 15,732 16,799 17,774
17,388 18,468 19,721 20,866
(71 Depreciation
..--
(8)
(9) 15.5% factor
Present value
67,388 68,468 69,721 70,866
0.866 0.750 0.650 0.562
58,358 51,351 54,319 39,827
Net cash flow
50,000 50,000 50,000 50,000
(IO)
194,855 200,000
Less outlay Net present
value
$(5,145)
About the Author is a lecturer in Accounting teaching of finance in the Bachelor of Business
Ray H. Anderson
Admin&tor. Accountin,g Business Research.
Forum,
at Footscray institute dcgrec in Hospitality
The Austrulim
Accmrntmt.
Victoria. of Technology. Studies. He has previously
Tire C‘h~rtc~rrd Aawtrntunr
Australia,
spcciatizing
published
in the Profec:viod
it1 Atrstrdin
and Auwuztitfg
in the
mrd
125
Inflation and impact on investment decisions in hospitality management
Appendix A Present value of a single sum
Future value of a single sum
P = S(1 + r)-”
s = P(1
Year
f 2 3 4
Discount factor W) IO
15.5
0.909 0.826 0.751 0.683
0.866 0.750 0.650 0.562
when S = future value of a single sum.
Year
+ i)”
Rate of inflation (O/of
5 ..--~-_-_-.._-___ :
1.05 1.102 1.158 1.216
8
1.08 1.168 1.260
1.360
where P = present value of a single sum.
Footscray Institute of Technology, Victoria 3011, Australia
The impact of inflation is more severe in the hospitality industry than in some others because of its high level of capital investment. Proper evaluation of investment returns can only be made if inflation is considered in the evaluation process. This article presents an approach based on the net present value method of investment evaluation which incorporates the anticipated level of inflation and provides for the uncertainties of future cash flows.
investment Key words: net present value
hospitality industry
introduction
cash flow
The net present value method stated as follows:
A recent feature of the Australian economy and those of other countries has been significant increases in the general level of prices of goods and services. Whilst such an inflationary environment affects all industries, its impact is more severe on the hospitality industry because of the high level of capital investment in buildings, fittings and equipment. Furthermore, as inflation will affect the returns obtained by firms operating in the hospitality industry, proper evaluation of investment opportunities will only occur if inflation is explicitly considered in the evaluation process.
l
t=f
where
NW
= the net present value of the proposal, = the estimated net cash flow each year for the proposal, = firm’s cost of capital, = life of the proposal, = investment outlay of the proposal.
NCF, k N 1,
The calculation of the net present value is shown in Example 1 for the following investment proposal: Example 1 Snack Foods Ltd. is considering investing $200,~0 in a piece of equipment which will be used to manufacture ‘Cheesies’, a new health food. The expected life of the equipment is four years and based on market research and cost estimates it is anticipated that the project will generate the following cash revenue and costs:
Net present value Finance literature has long demonstrated that the discounted cash flow method of net present value is superior to other methods of evaluation used for making capital investment decisions. Under this method the cash flows generated by an investment proposal are discounted using a firm’s cost of capital as the discount rate. Only the proposals whose discounted cash flows have a positive net present value shall in theory be undertaken by the firm. Vol. 2 No. 3 pp. 121-125
can be formally
NW=: (l+k)N -NCF, _ ()
The purpose of this article is to present an approach based on the net present value method of investment evaluation which incorporates the anticipated level of inflation and provide for uncertainties in future cash flows. By use of numerical illustrations it will be shown that failure to consider inflation may lead to erroneous investment decision making by management.
Int. J. Hospitality Management Printed in Great Britain
evaluation
inflation
121
Year
Revenue ($1
costs ($1
1 2 3 4
140,000 140,000 140,000 140,000
60,000 60,000 60,000 60,000
027%4319/83 $3.00 + 0.00 Pergamon Press Ltd
Ray H. Anderson
122
All cash flows are assumed each year.
to
occur at the end of
The only other expense will be that of depreciation which will be calculated on a straight-line basis over the life of the proposal. The proposal is expected to have no salvage value at the end of its life and the company pays tax at the rate of 46%. The company’s cost of capital is 10%. The discount factors for each year at 10%~ are set out in Appendix A. As Example 1 shows, the net present value method discounts future cash flows since it recognises that these flows have a lower present value than amounts received today (because these latter amounts can be invested and earn interest). The rate of interest considered relevant for discounting purposes is the minimum required rate of return (cost of capital). As the net present value is positive the proposal should be accepted. However, the presence of inflation requires that adjustment be made to the above model since the failure to allow for inflation may result in companies making incorrect capital investment decisions. Adjusting the net present value method for inflation - The net present value method can be adjusted to allow for inflation in either of two ways:
(9
(ii)
Calculate net present value by stating all future cash flows in terms of the dollars expected to occur and discount them at the minimum required rate of return (cost of capital) adjusted for inflation. OR Calculate net present value by stating all cash flows in real terms, that is, present day values and discount them at the minimum required rate of return (cost of capital) expressed in real terms.
Both methods.
Example
if correctly
applied,
will result
the same net present value. However, the first method has the advantages that it is easier to understand, better reflects what management is doing in practice and is more consistent with the information used for post-appraisal of investment decisions. Adjustment of cash flow and discount rate - From Example 1 it can be seen that the major components of the net present value method are the cash flows and the discount rate selected. The net cash flows will be affected by inflation since revenue, through increases in selling prices, and labour and other costs will increase. Depreciation expense will not be affected since it remains constant in amount once the asset is acquired. The discount rate used for discounting the cash flows is the cost of capital. This rate is determined by weighting the cost of finance provided by lenders and equity investors of the firm. Since lenders and investors will require a rate of return which will include an allowance for future inflation it is necessary to adjust the cost of capital for this factor. The inflation adjusted cost of capital is determined using the following formula: K = (1 + k) (1 + fI)-
1
where K = firm’s inflation adjusted cost of capital, k = firm’s cost of capital excluding any adjustment for inflation, n = expected annual rate of inflation. Using the earlier example, the cost of capital is 10% and if expected inflation over the next four years is 5%. the firm’s inflation adjusted cost of capital is 15.5% calculated as follows: K = (1 + 0.10) = 1.1551
(1 + 0.05) - 1
= 0.155 or 15.5%‘.
in
1
Year
(1) Revenue
(2) costs
1 2 3 4
140,000 140,000 140,000 140,000
60,000 60,000 60,000 60,000
(3) Depreciation
50,000 50,000 50,000 50,000
(4) Profit before tax
(5) Tax 46%
(6) Profit after tax
(7) Net cash flow (6)&(3)
(8) 10% factor
(9) Present value
30,000 30,000 30,000 30,000
13,800 13,800 13,800 13,800
16,200 16,200 16,200 16,200
66,200 66,200 66,200 66,200
0.909 0.826 0.751 0.683
60,176 54,681 49,716 45,215 209,788
Less outlay Net present
200,000 value
$9,788
inflation andimpacton
123
investmentdecisionsin hospitality management
discounts these flows using the inflation-adjusted cost of capital. It is assumed that inflation occurs evenly throughout the year in respect of cash flows.
discount rate to apply for The appropriate discounting purposes in this situation would be 15.5%. Example 2 calculates the net present value of the investment proposal using the inflation adjusted cost of capital as the discount rate whilst holding cash flows constant on the assumption that they are not affected by inflation. The net present value is negative and indicates that the proposal should be rejected. This is the opposite conclusion to the previous example where inflation was ignored in the analysis. This example shows that where the discount rate reflects inflationary expectations the failure to adjust cash flows for the level of expected inflation will bias the evaluation process and can lead to erroneous investment decisions.
Example 3 In order to ascertain the net cash flow for each year the revenue and cost amounts must be adjusted by the expected inflation rate to determine their future value. The factors used to determine these cash flows are set out in Appendix A. The proposal with inflation taken into account in the cash flows and the cash flows discounted at the inflation-adjusted cost of capital, now has a positive net present value. As noted by Van Horne (1971) the failure to adjust cash flows for the level of expected inflation when using a cost of
Example 3 adjusts net cash flows for the expected level of inflation of 5% per annum, and
Example 2
Year
ii, Revenue
_~ 1 2 3 4
._________.~ (31 Depreciation
(2) costs
..-
(4 Profit before tax
(5) Tax
(6) Profit after tax
30,000 30,000 30,oCIo 30,000
13,800 13,800 13,800 13,800
16,200 16,200 16,200 16,200
60,000 60,000 60,000 60,000
140,000 140,000 140,000 140,000
50,000 50,000 50,000 50,000
(7) Net cash flow KW(3)
03) 15.5% factor
(9) Present value
66,200 66,200 66,200 66,200
0.866 0.750 0.650 0.562
57,329 49,650 43,030 37,204 187,213 200,000
Lessoutlay Netpresentvalue
$(12,787)
Example 3 _-~I__.-... Year
Revenue ~....~-._-.-.-
1 2 3 4
Year
1 2 3 4
140,000 x 140,000 x 140,000 x 140,000 x -
(1) Revenue
147,000 154,280 162,120 170,240
1.05 = 147,000 1.102 = 154,280 1.158 = 162,120 4.216 = 170,240 -_________--
~ cost ---. ~__________~
60,000 x 60,000 x 60,000 x 60,000 x
1.05 = 1.102 = 1.158 = 1.216 =
(2) costs
____I__(3) Depreciation
(4) Profit before tax
(5) Tax 46%
63,000 66,120 69,480 72,960
50,000 50,000 50,000 50,000
34,000 38,160 42,640 47,280
15,640 17,554 19,614 21,749
63,000 66,120 69,480 72,960
(7) Net cash flow
(8) 15.5% factor
(9) Present value
68,360 70,606 73,026 75,531
0.866 0.750 0.650 0.562
59,200 52,955 47,467 42,448
(6) Profit after tax -__18.360 20,606 23,026 25,531
202,070 Lessoutlay Netpresentvalue
200,000 $2,070
Ray H. Anderson
124
capital which incorporates inflation will lead to a bias in the evaluation of investment proposals and may lead to erroneous decisions on the part of a firm’s decision makers.
The proposal would be rejected on the basis of the above quantitative analysis although qualitative factors may ultimately determine the final decision. Summary
and conclusion
The previous example has assumed that the rate of inflation will affect revenue, costs and the required return of lenders and investors by the same amount. However, it is likely that the effect of future inflation on the required rate of return will differ from that on the projected cash flows. Furthermore, the items comprising the cash flow may individually be affected differently by the anticipated level of inflation. Example 4 is based on an in~ation-adjusted required rate of return of 15% with revenue and costs subject to an inflation rate of 5% and 8% respectively.
In recent years significant increase in the general level of prices of goods and services has been experienced in Australia and other countries. The impact of such an inflationary environment will be severe on the hospitality industry due to its high level of capital investment. The article has therefore outlined an approach to incorporating inflation into the investment evaluation process enabling management to avoid erroneous decision making.
The net present value for the proposal is now negative following the incorporation of a higher cost inflation rate than that applicable to revenue.
Van Horne, budgeting
Example
Reference James C. (1971) A note on biases in capital induced by inflation. .Jo~~~rcl qj’ Firrmce wzd ~~~u?z~~f~t~~,~J Anffi~.~i.s653-658.
4
Year
Cost
Revenue
1
140,000
x 1.05
= 147,000
60,000
x 1.08
: 4
140,000 140,000
162,120 x 1.102 1.158 = 154,280 x 1.216 = 170,240
60,000 60,000
x 11.260 .I 68 = 70,080 75,600 x 1.360 = 81,600
__.~
---
..~_~
_..
= 64,800
.._ _
Year
~~
(I)
Revenue
~___
(2)
Costs
~_
(3) Depreciation
__..
.____.
(4) Profit before tax -...
:
154,280 147,000
70,080 64,800
50,000
34,200 32,200
3 4
162,120 170,240
75,600 81,600
50,000 50,000
36,520 38,640
(5)
Tax 46%
(6) Profit after tax
14,812 15,732 16,799 17,774
17,388 18,468 19,721 20,866
(71 Depreciation
..--
(8)
(9) 15.5% factor
Present value
67,388 68,468 69,721 70,866
0.866 0.750 0.650 0.562
58,358 51,351 54,319 39,827
Net cash flow
50,000 50,000 50,000 50,000
(IO)
194,855 200,000
Less outlay Net present
value
$(5,145)
About the Author is a lecturer in Accounting teaching of finance in the Bachelor of Business
Ray H. Anderson
Admin&tor. Accountin,g Business Research.
Forum,
at Footscray institute dcgrec in Hospitality
The Austrulim
Accmrntmt.
Victoria. of Technology. Studies. He has previously
Tire C‘h~rtc~rrd Aawtrntunr
Australia,
spcciatizing
published
in the Profec:viod
it1 Atrstrdin
and Auwuztitfg
in the
mrd
125
Inflation and impact on investment decisions in hospitality management
Appendix A Present value of a single sum
Future value of a single sum
P = S(1 + r)-”
s = P(1
Year
f 2 3 4
Discount factor W) IO
15.5
0.909 0.826 0.751 0.683
0.866 0.750 0.650 0.562
when S = future value of a single sum.
Year
+ i)”
Rate of inflation (O/of
5 ..--~-_-_-.._-___ :
1.05 1.102 1.158 1.216
8
1.08 1.168 1.260
1.360
where P = present value of a single sum.