Topic 50
Inflation in DCF Valuations
Topic 50 explores the impact and appropriate treatment of inflation in a discounted cash flow (DCF) valuation.
INCLUDE INFLATION IMPACTS IN DCF VALUATION
- Expected price and cost inflation should be reflected in forward cash flow projections when a nominal cost of capital (versus a real cost of capital excluding inflation) is utilized in a DCF valuation process.
- The reason for this is that the nominal cost of capital, by definition, includes a nominal inflation component.
- The inflation component implicit in the unlevered cost of capital,CU, the leveraged cost of capital,CL, and the weighted average cost of capital, C* is found in the risk-free rate, RF (long-term U.S. Treasuries), and in i, the interest rate on debt.
- RF and i are composed of perceived long-term inflation, approximately 2% to 3%, plus a real return of approximately 1% to 2%.
- The inflation component (in the discount rate) is intended to capture the expected devaluation of the purchasing power of a future value amount.
- Therefore, to derive a meaningful present value of a future cash flow stream, the stream should include the net impact of inflation when a nominal cost of capital is utilized.
- If the projected data used in a DCF valuation exercise are on a real, noninflated basis, when constructing the cost of capital, the nominal cost of capital should be adjusted to a real basis excluding inflation by deducting the implicit inflation factor included in both the risk-free rate ...
