Investment Planning under Variable Price Change

Abstract

The effects of inflation on equity claims and profits have attracted the attention of numerous writers. Earlier articles such as those by Kessel and Alchian [4] and DeAlessi [1] considered the relation between monetary assets and fixed-dollar obligations. Given that product prices change at the same rate as the prices of goods and services acquired, the query posed by Nichols [8] and Motley [7] was whether the change in the real value of tax claims greatly surpassed that of the real value of fixed-income claims. Other recent studies have looked into the inflation-hedge characteristics of common stocks [2 and 9] and have pointed to a potential bias introduced into capital-budgeting decisions by price-level changes [11]. This study confirms the erratic behavior of stock prices and corporate earnings as the price level changes, describes an investment-decision model that allows for both price-change expectations and interaction between stock prices and near-term earnings, and applies the price-change model to selected company environments. Preliminary analyses of the sensitivity of common stock prices, profits, and wholesale price and wage indexes to changes in the Consumer Price Index suggest that management either has failed to incorporate price-change expectations adequately into its decision fabric or has frequently misassessed actual rates of price change. The investrient-decision model-as set forth in this article-extends previous work in this area and merits serious consideration for application by corporate planners. Specifically, it rectifies deficiencies in other capitalbudgeting models by allowing for (1) differential rates of change in prices and costs and (2) management's subjective beliefs as to the rate of inflation. Despite its emphasis on near-term earnings, the model converges on the classical net-present-value decision rule at the limit.