Influence of inflation on investment selection

The current reality shows us a widespread and generalized increase in the prices of goods and services, which we basically call inflation.

Normally, and the most common way to measure this parameter, is through a price index, which corresponds to the annualized percentage of price variation over time; the most common index being the Consumer Price Index (CPI).

It should be noted that any type of interest or profitability measure originating from the market, such as: the return on government debt, the well-known APR or cost of a loan, or even the return on stocks, are all nominal values. But what does this mean?...

It means they include inflation. Thus, it is argued that...

Inflation will affect all magnitudes involved in an investment, especially cash flows and the discount rate.

In most investment projects, inflation will indeed affect cash flows. If the general price index increases, it will be logical for the company to raise the prices of its products by the amount it deems appropriate, thereby obtaining a higher cash flow than initially projected.

Generally, the increase in raw material or labor prices has a certain delay compared to the prices of finished products. Therefore, net cash flows increase when affected by inflation.

Regarding the aforementioned profitability measures or interest rates; all of them stem from a basic interest, or what is known as the legal interest rate (real interest without inflation), which we refer to as the price of using money in a hypothetical situation without inflation or risk.

Since we are talking about market-derived measures and rates, and as already mentioned, we are talking about nominal values, to obtain this nominal return, we will have to add an inflation premium and a risk premium to the real return (which is no other risk than that of the activity being invested in and the risk of losing the money lent).

There is a relationship between these values:

(1 + nominal interest) = (1 + real interest + risk premium) x (1 + inflation)

At first glance, it may seem simple, but what is the value of the real interest in the previous relationship?

In practice, the return on government debt is taken as the real interest, because it is assumed to be a risk-free investment, or rather, one with minimal risk.

To help understand everything that has been mentioned, a example:

Let's assume the average annual yield of the 5-year government bond rate in the secondary market is 5%.

This is a NOMINAL value because it's market-derived. To calculate the real risk-adjusted yield, assuming 3% inflation, we need to consider:

(1 + 0.05) = (1 + real yield + government debt risk premium) x (1 + 0.03)

Real yield + government debt risk premium = [(1 + 0.050) / (1 + 0.03)] – 1

Real yield + government debt risk premium = 1.94%

If the investment is estimated to have a risk differential compared to government debt of 10%.

• The real risk-adjusted investment rate:

(real government debt rate + government debt risk premium) + risk differential = 0.0194 + 0.10 = 11.94%

• The nominal risk-adjusted investment rate:

(1 + nominal rate) = (1 + 0.1194) x (1 + 0.03) = 1.1529 –>  15.29%

Therefore, the nominal rate for this investment will be 15.29%.

In the next post, we will explain how to calculate the risk differential based on a required return for a specific type of investment, also here on our blog.

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