Valuating Cash Flows in an Inflationary Environment: The Case of World Bank
VALUATING CASH FLOWS IN AN INFLATIONARY ENVIRONMENT: THE CASE OF WORLD BANK, Barbara T. Credan, ed., Trends in Inflation Research, Nova Publishers, 2006
76 Pages Posted: 4 Aug 2005 Last revised: 1 Apr 2009
Date Written: July 20, 2005
When valuating cash flows they should be based on estimates of free cash flows at nominal prices. In particular, we show that results from the valuation of cash flows with the constant and real price methods are biased upwards and there is a risk that in practice, bad projects will be accepted as good projects or that the valuation of free cash flows for valuing firms is overstated. Generally speaking, inflation has a negative impact on the Net Present Value of a project. When expected inflation rates over the cash flow horizon are high, which is a typically case in emerging and transitional markets, the use of the real and constant prices methodology could lead to serious mistakes in valuation.
Financial statements at constant or real prices will be of no use when the project is implemented because what occurs in reality (that is what we are interested in) is very different from what is written in the final report of a project evaluation. Some items are deflated while others (say depreciation charges and interest payments) are in nominal prices. For managerial purposes, it is useless to have this mixed information in the financial statements.
We present some examples where we show that the value of a cash flow should be based on estimates of free cash flows at nominal prices. It is an accepted practice to evaluate projects at constant or real prices. 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. It is a third party and near real life example (an example presented in the training material on economic regulation of public utilities developed by the World Bank Institute) we compare the results of the constant prices methodology with results of the nominal prices methodology. World Bank has played a crucial role in the development of the economies of the world, especially in the emerging countries. We recognize the leadership it has shown and the intellectual authority it has on planning offices, practitioners and consultants. For this reason it is critical whatever improvements made in the methodologies it uses in assessing the feasibility of infrastructure projects. This influence affects private practice in valuation and project appraisal as well.
We show how in the case based on the example from WB where they use some current practices several improvements to some areas of the model can be made, such as valuation at constant prices, mixing deflated and non-deflated items in a financial statements, using constant leverage when in the forecasted financial statements it is not constant, inconsistency in the cash flow and value calculations and some other irregularities that will be described in the body of the chapter. This analysis shows an overvaluation of more than 21% when the constant prices methodology is compared with the current prices methodology and using market values to calculate the WACC. This is a dramatic number.
Keywords: World Bank, regulatory policy for infrastructure, developing countries, project evaluation, project appraisal, firm valuation, cost of capital, cash flows, free cash flow, capital cash flow
JEL Classification: M21, M40, M46, M41, G12, G31, J33
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