Question

1. A member of a project team, acting on behave of the contracting authority, does not understand why your financial model must factor in inflation although the inflation has dropped to a single digit. Why should inflation be considered in the financial model although it is on a downward trend?

Answer 1

Should inflation be considered in the financial model

Inflation measures rate of increase in the general price level of goods and services in the economy over a period of time.

Inflation must be treated properly while preparing a financial model. If all the factors included in a financial model are affected in the same way, by inflation, the concept of inflation can be ignored. there sre some other cases in which some factors will be influenced by the inflation and others may not. Then we must consider the concept of inflation. Although it is on downward trend, it will affect the inflows of the project. And thus it will affect the profitability of the project. That is why the capital budgeting techniques like NPV and IRR are used in making project decisions.

So the financial model must factor in inflation although the inflation has dropped to a single digit.