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Chapter 4: Q11- 12DQ (page 360)

What effect would inflation have on a company鈥檚 cost of capital? (Hint: Think about how inflation influences interest rates, stock prices, corporate profits, and growth.)

Short Answer

Expert verified

It can only have a adversely affect on a company's cost of capital, constraining it to go up.This is accurate because inflation results in increased interest rates and lower share prices, so raising the cost of debt and equity directly and the cost of preferred stock indirectly.

Step by step solution

01

Introduction to inflation

Inflation is the rate at which the worth of any currency falls against the other international currencies and, thus, the level of prices in the wholesale and retail market for goods and services rises.Inflation aims to measure the general effect of price changes for a differentiated arrangement of products and services.

02

Effect of inflation on a company’s cost of capital 

Inflation generally means an increase in the prices and when it comes to the cost of capital, inflation always hits it up negatively.An increased rate of inflation would result to increase cost of capital, while cost of capital would be decreased at high rates of inflation by additional increases.

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Most popular questions from this chapter

Gibson Appliance Co. is a very stable billion-dollar company with a sales growth of about 7 percent per year in good or bad economic conditions. Because of this stability (a coefficient of correlation with the economy of +0.4, and a standard deviation of sales of about 5 percent from the mean), Mr. Hoover, the vice president of finance, thinks the company could absorb a small risky company that could add quite a bit of return without increasing the company鈥檚 risk much. He is trying to decide which of the two companies he will buy, using the following figures. Gibson鈥檚 cost of capital is 12 percent.

Genetic Technology Co. (cost \(80 million)

Cash Flow for 10 Years (\) millions) Probability

\( 2 0.2

8 0.3

16 0.2

25 0.2

40 0.1

Silicon Microchip Co.(cost \)80 million)

Cash Flow for 10 Years (\( millions) Probability

\) 5 0.2

7 0.2

18 0.3

24 0.3

a. What is the expected cash flow from both companies?

b. Which company has the lower coefficient of variation?

c. Compute the net present value of each company.

d. Which company would you pick, based on the net present values?

e. Would you change your mind if you added the risk dimensions to the problem? Explain.

f. What if Genetic Technology Co. had a coefficient of correlation with the economy of -0.2 and Silicon Microchip Co. had one of +0.5? Which of these companies would give you the best portfolio effects for risk reduction?

g. What might be the effect of the acquisitions on the market value of Gibson Appliance Co.鈥檚 stock?

Dixie Dynamite Company is evaluating two methods of blowing up old buildings for commercial purposes over the next five years. Method one (implosion) is relatively low in risk for this business and will carry a 12 percent discount rate. Method two (explosion) is less expensive to perform but more dangerous and will call for a higher discount rate of 16 percent. Either method will require an initial capital outlay of \(75,000. The inflows from projected business over the next five years are shown next. Which method should be selected using net present value analysis?

Year Method 1 Method 2

1 .................................... \)18,000 $20,000

2 .................................... 24,000 25,000

3 .................................... 34,000 35,000

4 .................................... 26,000 28,000

5 .................................... 14,000 15,00

Question: Phil Goode will receive $175,000 in 50 years. His friends are very jealous of him. If the funds are discounted back at a rate of 14 percent, what is the present value of his future 鈥減ot of gold鈥�?

If a corporation has projects that will earn more than the cost of capital, should it ration capital? (LO12-5)

Why is the remaining time to maturity an important factor in evaluating the impact of a change in yield to maturity on bond prices?
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