What is the likely effect of inflation on the level of capital expendi

QUESTION

What is the likely effect of inflation on the level of capital expenditures made by private firms? What must the financial manager do to ensure that a firms capital budgeting procedures will be effective in an inflationary environment?
Answer: Inflation indicates general trend of rise in price of commodities in the market which led the prices to rise. This happens when there is excess money in the economy chasing goods. Normally under such circumstances Central Bank increase interest rate which to increase in borrowing cost and as a result cost ofcapital expenditures made by private firms increases sharply which effect the Internal Rate of Return and Cash flows of the firm. Sometimes in adverse situation, project may become unviable as increasing interest rate has cascading impact on Currency which may lead to sharp depreciation. European¦

es after World War 11 clearly indicate the crises and impact of inflation which economy had suffered. In order to ensure that the cash flow is protected firm should take adequate protection against interest rate and should hedge the floating rate with fixed leg in order to cap the interest outflow. Furthur, firm should make a contingent reserve and should incorporate it in the cost so meet such extra contingencies.

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