Cashflow forecasting in country with high inflation

william

Hi all,

A friend of mine asked me an interesting one and both of us would welcome your thoughts and theory on this. An individual is looking to build and operate a building in a country with high inflation. Borrowing and cost projection data is denominated in Euro but rentals will be in the local currency. As he needs to simulate cash flows, would the following work?

Information available
Exchange rate: say €1 = 5 of local currency
Loan: €100,000@6-7% for build and thereafter.
(one cannot borrow locally but if it was available it would be at an interest rate > 15%+. Euro loan is to be drawn down and converted to local currency as required)
Local inflation: say 15%
Euro inflation: say 2%
Rents: 50,000 (local currency, therefore equiv to €10,000p.a)
Outgoings: 40% of rentals
Build cost: €120,000

My approach
Project all cash flows in euro
Project rents in Euro and show them growing at 2% (as opposed to 15%)
use loan interest rate of 7% (as opposed to 15%)
Costs will be 40% of rentals (effectively growing at 2% as they are a function of rents)

Question
My logic is based on purchasing power parity, i.e. 5th year rents in local currency growing at 15% p.a. with an exchange rate moving also such that rent in year 5 will be the equivalent of €10,000 x (1.02)^5.

Does my approach work?

Many thanks,

William

Anonymous1987

If local inflation is 15% and Euro inflation is 2%, shouldn't the inflation rate you use be the difference between the two hence rents should be decreasing at 13% per inflation period excluding any other changes if you are paying in Euro?

Think about it using the quantity theory of money: M.V=P.Q, holding V (velocity) and Q (quantity of money) constant, the money supply (M) has a direct relationship with the price level (P). Hence the 15% inflation is an increase in the money supply of that economy. An increase in the money supply lowers the "price" of that currency, i.e. the amount of Euros needed to purchase the local currency so the Euro appreciates. Since the Euro is also facing inflation albeit at a much lower rate the difference between the inflation rates will give the real currency appreciation, the 13% difference between Euro and local inflation.

So, use the Euro inflation rate when cashflow/financing is in Euro, otherwise use the inflation rate difference for local cashflow/financing to get the real exchange rate. To answer your question rents in local currency should be €10,000 x (1-0.13)^5.

william

Thanks for that. If the theory supports, then I think it is best to express all figures in Euro and to have the rents escalate at the 2% which in turn pay costs and pay back the euro loan.

Anonymous1987

Sorry, just re-read your post and realised that you are letting rents grow at the rate of local inflation. In that case your approach is correct as far as I can see.