Inflation is the rate at which prices of goods and services are rising, thereby, the value of a currency is declining. Most commonly, the indexes are the Consumer Price Index (CPI) and Wholesale Price Index (WPI).
Estimating the Expected Inflation Rate is the third step in the Process of Valuation. Expected Inflation is the Expected Inflation Rate of the Currency in which the valuation is done and one expects to be during the forecast and terminal period. The same rate should normally be built into the risk-free rate, the cost of debt and cost of equity, which are used in determining the cost of capital during the forecast and terminal period.
To elucidate: If the real interest rate of a country is 2% and the expected inflation rate is 5.25% then the Risk Free Rate should be 7.25%. Further if a company's default spread is 2.5%, then the pre-tax cost of debt is 9.75%. It is necessary to understand that the risk-free rate is the real interest rate + expected inflation rate which is 2% + 5.25% = 7.25%
One should assume the same inflation rate in the cost of capital else the valuation will be inconsistent. In most cases, we should also assume the impact of inflation on sales growth.
The inflation rate should be of the currency in which the valuation is done. Further, the cost of debt and cost of equity should incorporate the inflation rate assumption.