Use of Inflation as the Basis to Estimate Nominal Increases in Prices

Abstract

When estimating future or pro forma financial statements and free cash flows we need to estimate future prices. In doing this we must estimate nominal increases in prices of many items, for instance selling prices, inputs prices (raw material, labor, overhead, etc.), cost of future debt, and others. If we set nominal price increases without a proper link to inflation we might end up with price increases independent of the inflation rate. The purpose of this teaching note is to present an approach to estimate nominal price increases examining historical nominal prices and inflation rates. This way we can "discover" which policy, if any, the decision maker used to fix prices assuming that she has a fair estimate of immediate future inflation rate.

This approach can be used to asses the risk premium a debt holder (in case it is a bank loan) is applying to the cost of debt. This way we could estimate the cost of future debt, given an estimation of future inflation rate.

We present an appendix where the formal assumptions that has to be met for robust econometric analysis.

Keywords: inflation, nominal price increase estimation, inflationary environment, price level, project evaluation, firm valuation, capital budgeting, project evaluation

JEL Classification: D61, G31, E31, H43, E47