Inflation and the Constant-Growth Valuation Model: A Clarification

Abstract

We examine the effects of inflation on the standard, Constant-Growth valuation model found throughout the finance literature. We find that the presence of inflation vitiates the generally accepted expression of this model for the value of a firm that either makes no new investments or invests only in zero net present value projects. If expected inflation is positive, the generally accepted and widely used expression for the value of the firm under either of these two conditions seriously understates the true value of the firm, even at modest levels of inflation. For example, assuming zero net new investments, a real interest rate of 6% and a rate of inflation of 2%, the commonly accepted expression understates the true value of the firm by 25%. We also examine the effects of inflation on the firm's weighted-average cost of capital (WACC), which is an important parameter in the Constant-Growth model. We find that the popular WACC equation developed by Modigliani and Miller is not inflation-neutral when stated in nominal terms. Specifically, when expected inflation and corporate tax rates are positive, the nominal M&M WACC understates the firm's true nominal WACC by a non-trivial amount. We show how to adjust the standard M&M formula to correct for this understatement. In contrast to the M&M model, we find that the WACC equation developed by Miles & Ezzel is inflation-neutral when stated in nominal terms, and thus, there is no need to adjust the equation in the presence of positive expected inflation. We conclude the paper by documenting the widespread misapplication of the Constant-Growth model under conditions of inflation found throughout the finance literature and in the practical application of corporate valuation techniques.