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A Note on Biases in Capital Budgeting Introduced by Inflation

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  • Van Horne, James C.

Abstract

In the allocation of capital to investment projects, it is unlikely that optimal decisions will be reached unless anticipated inflation is embodied in the cash-flow estimates. Often, there is a tendency to assume that price levels remain unchanged throughout the life of the project. Frequently this assumption is imposed unknowingly; future cash flows are estimated simply on the basis of existing prices. However, a bias arises in that the cost-of-capital rate used as the acceptance criterion embodies an element attributable to anticipated inflation, while the cash-flow estimates do not. Although this bias may not be serious when there is modest inflation, it may become quite important in periods of high anticipated inflation. The purpose of this note is to investigate the nature of the bias and how it arises.

Suggested Citation

  • Van Horne, James C., 1971. "A Note on Biases in Capital Budgeting Introduced by Inflation," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 6(1), pages 653-658, January.
    • Handle: RePEc:cup:jfinqa:v:6:y:1971:i:01:p:653-658_02
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    Cited by:

    1. Freeman, Mark C., 2009. "The practice of estimating the term structure of discount rates," Global Finance Journal, Elsevier, vol. 19(3), pages 219-234.
    2. Zurita, Salvador & Castillo, Augusto & Niño, Jorge, 2019. "Inflation, tax integration and company valuation: The Latin American case," Journal of Business Research, Elsevier, vol. 105(C), pages 370-380.

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