How does inflation affect DCF calculations?

Inflation significantly impacts Discounted Cash Flow (DCF) calculations because it influences both cash flow projections and the discount rate used for valuation. When estimating future cash flows, inflation must be considered to ensure that projections reflect the actual purchasing power and economic conditions expected over time. If inflation is expected to rise, it typically results in higher costs for materials, labor, and other operational expenses, which should be factored into the cash flow projections.

Moreover, the discount rate, which reflects the opportunity cost of capital, often includes a component for expected inflation. By adjusting both the cash flow projections to reflect anticipated inflation and the discount rate accordingly, analysts can arrive at a more accurate measure of the present value of future cash flows. This comprehensive approach allows for a more realistic valuation that considers the time value of money in an inflationary environment.