CHAPTER 2: THE THEORETICAL UNDERPINNINGS OF THE EQUITY
2.4 Criticisms of the Neutrality Assumption
Cases where inflation is non-neutral, which are generally thought to occur more often and step outside the bounds of such simple finance theory as has been previously discussed, occur when the effect of inflation on cash flows is different to the effect on the discount rate. The most common of these cases is where the firm cannot increase nominal cash flows in line with
inflation costs and so would experience a decrease in real value. In this case the elasticity between inflation and cash flows would be less than unity, meaning that if inflation increases by 1% cash flows would increase by less than 1%. In the more extreme case, it is possible that inflation and cash flows might have a negative elasticity for several reasons (Farsio and Fazel, 2008). For example, a decrease in the real wealth of consumers due to inflation may influence purchases of substitutes for a firm’s goods and could, if the elasticity between inflation and cash flows is negative, cause an increase in inflation to have a negative impact on cash flows, which would drastically decrease the NPV of the firm. Another cause of this negative elasticity might be the negative relationship between inflation and real equity returns alongside the positive relationship between real activity and equity returns proposed by Fama (1981), a concept discussed in more detail in later on in this chapter. In this case an inflationary increase would negatively impact on real economic activity which, in turn, would negatively impact equity prices as a result of decreased activity of the firm, based on the negative relationship between equity prices and real economic activity. The alternate non-neutral case is when the elasticity between inflation and cash flows is greater than 1, where a 1% increase in inflation would result in an increase in cash flows of more than 1%. While this would theoretically be rare in practice as it would be unlikely for firms to increase profits following an increase in real costs, it should be noted at this point however, that such occurrences have been observed in the literature, some of which are discussed in chapter 3, including the findings of Alagidede and Panagiotidis (2010).
Damodaran (2012) states that under inflationary conditions valuation is often conducted in real terms. This means that cash flow estimation is conducted using real growth rates while excluding the growth resulting from price inflation. In order for the results to be accurate and reliable, the discount rates used in such cases need to be the real discount rates. In order to determine a real expected rate of return, a real risk-free rate must be calculated. Government and treasury bills are usually used as a determination of the risk-free rate, but these are only risk free in nominal terms because they cannot account for expected inflationary volatility. The most reliable measure of the determination of a real risk-free rate is to subtract the expected inflation rate from the nominal interest rate, which can then be used to calculate the real expected rate of return (Damodaran, 2012). For the sake of simplicity, it has generally been acceptable to observe inflation as a neutral process that does not have lasting effects on relative prices; however, it has been recognized in the literature that the impact of inflation on the real and market rates of return is essentially inconsistent. Changes in these rates generally lead to
an adjustment of the required rate of return, which is discussed in the next section, or a disproportionate adjustment of the nominal rate of return for the particular project (Mehta et al., 1984).
The inflation-neutral case discussed previously is a scenario that links to the Fisher (1930) hypothesis discussed in the next section (Bodie et al., 1999). This illustrates that when the NPV, or real return, of an investment is unaffected by inflation due to an increase in cash flows equal to the increase in the discount rate, that investment would act as a perfect inflationary hedge.
The assumption included in the CGM that a firm makes no new net investments and has a nominal growth rate of zero in the long-run – based on the theory that in the long-run competition and technological innovation will result in normal rates of return - effectively ignores the effect of inflation on the company’s total capital investment which should in fact grow at the same rate as inflation (Bradley and Jarrell, 2008). Following this logic, under the assumption of a consistent real return on capital investment, the company’s nominal cash flow derived from these investments should experience an equal growth rate. Therefore, in the presence of inflation, the Constant-Growth model tends to value a firm beneath its true value (Bradley and Jarrell, 2008).
Often common fundamental financial textbooks (Hillier, Ross, Westerfield, Jaffe and Jordan, 2010) teach that valuation must be conducted from either a real or nominal viewpoint in order to handle the effects of inflation. This theory holds if inflation is neutral, but as previously mentioned, there are a number of reasons in reality not to assume that inflation is neutral. One such reason investigated by Ezzell and Kelly (1984) is tax-related capital structure considerations, which have not been adequately incorporated into previous work on the effect of inflation on capital budgeting theory. They discovered that the previously held conclusions regarding inflationary effects hold only if the personal tax rate on debt is equivalent to the corporate tax rate or in the case where leverage is irrelevant. When the tax effects of debt- financing are limited to the corporate tax shield and the personal tax liability on the firm’s interest, the levered market value of a project can be defined as the sum of the values of the equity and debt claims against the total expected cash payoff for the project at the end of one period.
Ezzell and Kelly (1984) demonstrated that when leverage matters and when inflation has a uniform effect on cash flows inflation has three unanticipated effects. Firstly, they demonstrated that inflation would in fact raise the NPV of projects under the aforementioned conditions i.e. that the NPV under the effects of inflation is greater than the NPV when inflation is disregarded. Secondly that the appropriate discount rate for nominal cash flows is less than the discount rate calculated by grossing up the real discount rate by the rate of inflation and finally that the discount rate that is appropriate for valuing real cash flows declines as the inflation rate rises. For a description of the models used to arrive at these conclusions the reader is referred to the original paper by Ezzell and Kelly (1984). Ezzell and Kelly (1984) state that the implication of these results is that if the cost of capital that was appropriate during a period of no inflation is scaled up by the rate of inflation and used to discount nominal cash flows, some projects which would raise a firms levered value would in fact be rejected. On the other hand, if projected nominal cash flows when inflation was positive were converted into real cash flows and discounted by the cost of capital taken when inflation was zero, then some projects would also be rejected which would have had a positive impact on the value of the firm.
The impact of inflation on the discount rate is essentially uneven, as discussed in detail by Mehta et al. (1984) who specify distinct formulations for the valuation of the present value of a project’s cash flows in three cases, these being the incremental real profit per unit, the nominal cash flows and the real cash flows valuations techniques. They state that in the case where inflation is assumed to be neutral and uniform processes and taxes are ignored all three valuation techniques are identical. Mehta et al. (1984: 49) later state: “However, inflation is not neutral.” Additionally, they state that subsequent to the recognition that inflation has uneven effects on various cash flows and by extension on the value of the firm, one must recognize that the risks linked to the various firm’s cash flows are also unequal. They write that a capital project would provide a full inflationary hedge in the case where the total inflationary risk does not influence the capital project, where the real rate of return on the project adjusts independently of inflationary variations. Should this not be the case, inflation would have varying effects on various firm’s cash flows which would cause the magnitude of risk to be associated with each of the firms to differ, based on their capacity to provide an inflationary hedge. Mehta et al. (1984) point out that in an efficient market this inequality would be recognized and would subsequently be incorporated into firm’s capitalization rates, which would mean that the determination of a nominal discount rate by multiplying the real discount rate by the rate of inflation would be unlikely to correctly capture the markets’
required adjustment, as was also determined in the previously discussed study by Ezzell and Kelly (1984).
Mehta et al. (1984) provide an interesting discussion of how the introduction of corporate taxes further aggravates the aforementioned issue of inconsistency. To summarise their discussion, they present the example of the depreciation tax shield, which is a fixed, nominally defined cash flow whose real value is inflation-dependent. In two otherwise identical firms, which differ only in their capital intensities, the firm with a greater capital/labour ratio would pass a greater proportion of aggregate cash flow through its depreciation tax shield. As such, this firm would be more hard-pressed to provide sufficient real returns to act as an inflationary hedge and, furthermore, would experience a greater variability in cash flows due to inflationary adjustments; further increasing the risk associated with this more capital-intensive firm. By extension, even when the real cost of capital is equal under a specific inflation rate for two firms, their real cost estimates may be different should the inflation rate adjust. For this reason, it is unlikely that adjusting the real required rate of return for inflationary changes would result in the correct cost of capital for the firm, instead it would result in an incorrect estimation of the value of a project (Mehta et al., 1984). Based on these arguments that present potential flaws in the neutrality assumption, it is unlikely that the Fisher Hypothesis, which proposes that the real interest rate is comprised of the nominal interest rate minus the inflation rate, would in fact hold in reality.
Even in the case where the firm is able to fully pass on the costs associated with inflation to its customers the consideration of the impact of the nominal price increases on the sales of the product must be taken into account. In addition, the uneven effects of inflation on capital costs as well as the on labour would also have an effect on the capital budgeting procedure of a firm during an inflationary period, all of which are factors that make it increasingly unlikely for inflation to be neutral, thus violating the neutrality assumption of the Fisher Hypothesis. The arguments for neutrality and non-neutrality of inflation are reflected by two of the fundamental arguments regarding the theory in the literature, these being the Fisher Hypothesis and the Proxy Hypothesis, which are discussed in the next two sections of this chapter.