How does inflation impact DCF cash flow projections?

Inflation is a critical factor to consider when making Discounted Cash Flow (DCF) projections, as it affects both the nominal and real values of cash flows. When inflation rises, the general price level increases, which can lead to higher nominal cash flows. This means that a company may expect to receive more money in nominal terms as prices increase over time. However, it is essential to note that while nominal cash flows may rise, the real value, which accounts for inflation, does not necessarily increase in the same proportion.

In this context, the nominal cash flows can seem healthier and more attractive due to the inflationary environment, but the purchasing power of those cash flows may not reflect a true increase in value when adjusted for inflation. Essentially, an investor must look beyond nominal figures and consider how the inflation-adjusted (real) cash flows impact their overall return and the value of the investment.

This understanding is critical for accurately estimating the present value of future cash flows and assessing the investment's viability. Projections must account for inflation so that the resulting figures provide a realistic view of the potential economic value generated by the investment.