Inflation - Effects on Cost of Capital and Profitability
Effect on Liabilities
Inflation has positive effects in the liabilities
side of the balance sheet, as it diminishes the present value
of monetary liabilities such as long term loans.
Effect on Assets
But this advantage usually does not fully compensate the negative effects that inflation has in the assets
side, such as the loss of value of cash and receivables, and deviation of calculated depreciation among others.
Effect on Earnings
To counterweight the effects of inflation, companies should pass the full cost of inflation to customers, but also have to increase earnings
at a rate higher than the inflation percentage in order to compensate for lower depreciation. Depreciation
during inflationary periods is lower than the cost of replacement of depreciable assets and offers less tax shelter. To maintain the generation of cash flow, it is necessary to achieve rates of earnings growth above inflation, and sometimes this can be a daunting task.
Effect on Share Price
Also, during inflationary periods, the higher cost of capital
in real and nominal terms reduces the present value of expected future cash flows and the calculated value of share prices
. Financial markets liquidity, which might be present during inflationary periods, might not be enough to increase demand of shares and avoid poor stock market performance unless liquidity is also accompanied with a substantial appetite of investors for risk.