A model for the selection of investment projects under inflationary conditions

Abstract

Current methods of investment appraisal under inflation are shown to have deficiencies that may result in the wrong selection of investment opportunities. A more efficient alternative is proposed here, that looks into two aspects of the problem: (1) the analysis of independent projects, and (2) the analysis of corporate investment decisions over the long term, involving several interdependent projects. For the first case, a variant of common discounting techniques is used. This method, called “Terminal Value”, is based on the projection of cash flows to obtain an estimate of the net incremental wealth that would be attained if the project in question was adopted. In doing this, the method takes account of the effect of inflation on the fixed investment, and the different treatment given to the amounts of debt and equity used to finance the project. This results in a more realistic appraisal of opportunities. The method can deal with minor interdependencies between small sets of projects. For the case of several interdependent projects over a certain planning horizon, where decisions are linked to problems of liquidity, limited availability of funds and subject to much higher risk, a Mixed Integer Programming simulation model is proposed. This model maximises “Terminal Value” subject to constraints on cash balance, liquidity, gearing and taxation. The choice of this particular set of constraints responds to the need to check those factors on which the effects of inflation are more damaging. The model is based on the premise that inflation forecasts are very imprecise. Thus, to account for the inherent risk, the project selection criterion is such that the chosen portfolio is the one the highest probability of being optimal for the inflation scenario that materialises. An estimate of the portfolio’s sensitivity to inflation is also produced by the model.