How Inflation Affects Cost of Capital and Profitability
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.
Nevertheless, this advantage does not usually 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.
To counterweight the effects of inflation, companies do not only have to pass the full cost of inflation to customers, but also have to increase earnings at a rate higher than inflation 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.
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.