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Inflation and Cost of Capital

May 17th, 2010

Lower interest rates on the ten-year Treasury (risk-free rate) do not always lead to a lower cost of capital. This was clearly seen during 2008 as interest rates fell yet cost of capital rose, as credits weakened due to the effects of the recession and illiquid credit markets. Conversely, higher rates may not always lead to higher cost of capital, as particular industries benefit from (the fear of) inflation and price increases relative to costs. Where the yield spread and risk-free rate do not capture inflation on the security level,  we adjust cost of capital.
Contrary to popular thinking, a rise in inflation cannot be overcome by a similar rise in revenues-it must be overcome by a similar rise in free cash flows, or cost of capital will increase. Also to be taken into account is the effect of inflation on capital to be replaced. If the cost of such capital has increased at a rate greater than the increase in free cash flows, this metric would result in a greater penalty.
The inflation rate affects economic and business risk, including the value of balance sheet inventory, which may be severely understated for firms using LIFO accounting. And, as history has shown (see Illustration), the impact of inflation is not always accurately divined in the risk free rate, which is used as the beginning building block for the cost of equity capital model. Also, the inflation rate and the expected rate of inflation affect firms differently, and thus this metric may need to be adjusted for those groups. Those enterprises with high leverage, sensitive to commodity price swings, or those enterprises that own significant investments whose values are tied (directly or indirectly) to the level of interest rates, will be more greatly affected by changes in the expected rate of inflation than those entities which can pass along its consequences, such as some utilities.

S&P500 Index

Risk Free Rate

Risk Free Rate

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