INFLATION AND THE MARKET VALUE OF THE FIRM: THEORY AND TESTS

Abstract

INFLATION CAUSES WEALTH TRANSFERS among different sectors of the economy, consisting of business firms, households and the government. Where they affect business profits, these transfers take place over and above the nominal increase in the value of the firm that follows from a general price level change. In the absence of the distortions represented by these transfers, classical theory of macroeconomic equilibrium would require that nominal equity values increase in exactly the same proportion as the price level'. Under such ideal conditions, a 10% increase in the general price level, for example, would involve a 10% increase in the nominal value of all assets. Firms would neither enjoy capital gains nor suffer losses, in real terms, as a consequence of the price level change. This is consistent with the fact that real returns from capital are dependent only on production functions and factor proportions, which are invariant to price levels. However, the presence of wealth transfers due to inflation would imply that this fundamental postulate need no longer hold: the market value of the firm would not be homogeneous of degree one in the price level. These considerations naturally raise the perennial question of whether or not common stocks are a good hedge against inflation. More generally: what is the statistical relation between inflation and stock prices? Past studies have been concerned mainly with the relation between aggregate stock market levels and inflation rates, and the results have been varied and sometimes inconclusive.2 Less attention has been paid to the fact that inflation can affect individual firms in vastly different ways. Firms differ from one another in capital structure, asset composition, and the method of reporting income for tax purposes. These variations cause differential effects of inflation on their stock prices. This paper studies these differential effects. It is important to distinguish the monetary assets and the real assets of a firm. A monetary asset is one whose amount is independent of price level changes. It includes cash, marketable securities and receivables as positive assets and debt and