Valuation in an Inflationary Environment

Abstract

Using illustrative examples, this paper shows that the Net Present Value for project evaluation should be based on estimates of free cash flows at nominal prices. It is a widespread practice to evaluate projects at constant or real prices. These days, the use of constant or real prices is an unnecessary oversimplification. In particular, we present an example where the results from the constant and real price methodologies are biased upwards and there is a risk that in practice, bad projects will be accepted as good projects.

Keywords: Project evaluation, engineering economy, NPV, Net Present Value, inflation, constant price methodology, current price methodology, nominal price methodology, free cash flows, pro-forma financial statements, relative prices

JEL Classification: D92, E22, E31, G31