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How critical are inflation rate assumptions to investment values?

We have been lucky in the past decade (indeed for thirty years) to be blessed with consistent levels of inflation, and subsequently stable (and very low) interest rates. This has allowed for low-cost borrowing and prevented the value of money from diminishing at a rapid rate. It has not always been the case in the UK or indeed around the world. Venezuela and Zimbabwe are examples of where inflation has been excessively high, or “hyper”, where wages being received on a Friday were worthless by the Monday morning. In the UK in the 1980s, inflation reached 20%, which is difficult to comprehend from recent history.


Inflation has been below 5% for thirty years, but the previous twenty years were turbulent, almost reaching 25% in 1975. The rise coincided with negotiations to join the EU from 1969 and didn’t stabilise until the European Economic Community became the European Union with the conclusion of the Maastricht Treaty in 1992, immediately after ‘Black Wednesday’ when the UK ended its disastrous flirtation with the Exchange Rate Mechanism of the European Monetary System.


Ignoring the specific reasons, just think about the underlying political turbulence driving economic turbulence and, tellingly, the fact that successive UK Governments failed to stem the problems until Maastricht.


Brexit, the recent pandemic, and Ukraine are turbulence factors the likes of which have been missing from our past thirty years and make it exceedingly difficult to predict ongoing economic consequences. What we do know is that the short to medium-term economic future looks unpredictable, and inflation reaching 7% at the turn of this fiscal year is not a great start.

Inflation has the effect of weakening the value of future cash in today’s terms, meaning we must seek better investment returns to gain an advantage, or our purchasing power reduces. Therefore, when we are appraising investments, we surely must take inflation into account.

Modelling using cashflows with varying inflation rates over each year of the forecast and a nominal discount rate ensures the investment can be viewed and compared with others holistically.



If we are applying inflation to our Housing stock income streams, we must inflate different streams at different rates as not all will be inflating at the same rate. Despite the inflation rate in the wider economy being some 7% in April 2022, your organisation may be noticing some other costs are rising at a much higher rate (such as planned replacements of kitchens, boilers, and other major components). This cannot be attributed to one factor or else economists would be out of a job! There are multi-factor models used to predict inflation, but these are only as good as the reliability of the information being fed into them, we are recovering from a global pandemic, and still navigating Brexit (let’s not forget EU switching costs between 1975 and 1992), and increasing uncertainty with global supply chains are all factoring into these price increases.


Setting the inflation to the correct level is rather an arduous task and cannot be underestimated as misjudging the inflation, can cause significant differences in your NPV results as per the example below with a 6% discount rate.


Year

1

2

3

4

Inflation A

2%

2%

2%

2%

Inflation B

6%

6%

6%

6%

​Inflation C

15%

15%

15%

15%

Net Cashflows

£1,000,000

£1,000,000

£1,000,000

£1,000,000

A - Inflated

​£1,020,000

£1,040,400

£1,061,208

£1,082,432

B - Inflated

£1,060,000

£1,123,600

£1,191,016

£1,262,477

C - Inflated

£1,150,000

£1,322,500

£1,520,875

£1,749,006

NPV A = £3.6M

NPV B = £4.0M

NPV C = £4.9M


On the £1 million investment positive cash flow example above, simply changing the inflation has a significant impact on the NPV over a 4-year period. When evaluating a 30-year NPV this effect is compounded and can have a substantial impact on the final figures reported. This will inflate your NPV values this year, but then in years to come when inflation settles once again, the group NPVs will then report lower, and justifications for this will need to be made. Therefore, it is particularly important to ensure the figures being used in the forecasting model are the best representation they can be at the time of preparing the reports, and that the bases and assumptions are well documented and robust.


Inflation is not all bad news for all business sectors as it can drive profitability through increasing margins or even capital value, as it did in the 1980s when asset-stripping produced huge bonuses for business acquirers disposing of unproductive assets and turned poor business investments into vast wealth for many individuals. However, in the social housing sector, inflation is bad news and must be carefully considered when investing and divesting.

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