Question

. What impact does the high inflation have on the value of a business? Explain briefly.

Answer 1

High inflation decreases the value of business. It does by affecting both the future cash flows and the discount rate. And value of a firm is the present value of expected future profits so the negative effect on both the future cash flows and the discount rate (or cost of capital) leads to lower value of the firm.

There are two ways a company reacts to inflation. First approach is by increasing the price of their products which is basically transferring the effects of increase in prices of raw materials to the customers. However, the customers might decrease their buying as the prices are high. Hence, change in revenues depend on the elasticity of the product. Generally, the profits go down. Second approach is by keeping the price constant and hence absorbing all the effects of inflation themselves. This means lower profits. So we see in both the approaches, higher inflation generally means lower profits.

Their cost of funds is tied to inflation so when inflation increases, cost of doing business goes up hence the present value of future expected profits goes down.

Thus we see both effects decrease the value of firm.