How can inflation rates influence investment appraisal outcomes?

Inflation rates can influence investment appraisal outcomes by affecting the real return on investment and the cost of capital.

Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. When appraising an investment, it's crucial to consider the potential impact of inflation on the projected returns. This is because the real return on an investment, which is the return after accounting for inflation, may be lower than the nominal return, which is the return before accounting for inflation. If the inflation rate is high, the real return on an investment may be significantly lower than the nominal return. This could make an investment seem less attractive than it initially appears.

Moreover, inflation can also influence the cost of capital, which is the cost of a company's funds (both debt and equity), or, from an investor's point of view, the required rate of return on a portfolio company's existing securities. Inflation can increase the cost of capital in two ways. First, it can increase the cost of borrowing. When inflation is high, lenders typically demand higher interest rates to compensate for the decrease in purchasing power of the money they will be repaid in the future. This can increase a company's cost of debt, which in turn increases its cost of capital. Second, inflation can increase the required rate of return on equity. When inflation is high, investors typically demand a higher return on their investments to compensate for the decrease in purchasing power of their future returns. This can increase a company's cost of equity, which in turn increases its cost of capital.

In conclusion, inflation rates can significantly influence investment appraisal outcomes. They can reduce the real return on investment and increase the cost of capital, both of which can make an investment seem less attractive. Therefore, when appraising an investment, it's crucial to consider the potential impact of inflation on the projected returns and the cost of capital.