Valuation: Measuring and Managing the Value of Companies, Fifth Edition

Chapter 29 Solutions
Inflation
1. The general reasons are that the firm cannot pass on inflation in full to its customers, and
the cost of capital increases more than the free cash flow. One way to look at the situation
is by the direct and indirect effects. The direct effect is the decline in the real value of
liquid, nonoperational assets such as cash and accounts receivable. The indirect effects
include the lowering of the effectiveness of the depreciation tax shield, the loss in sales
from raising prices, and the increase in the cost of capital required by investors.
2. The ROIC would initially go up more for the firm with long-lived assets because the
returns will increase with inflation while the book value of invested capital will not
change. Over time, as the benefits of the depreciation tax shield from the fixed assets
decline and the firm has to replace the longer-term assets, the ROIC for the firm with
short-lived assets would increase more.
3. High inflation introduces many distortions. Depreciation and the replacement costs of
assets on the balance sheet are understated. On the income statement, the sales and profit
margins for periods within the reporting period (e.g., the year) will not be directly
comparable, nor will the associated returns on investment. Other distortions include
overestimation of growth, overstatement of capital turnover, overstated operating
margins, and distorted ratios.
4. For the assets currently on the books, the depreciation tax shields will decline in value.
This decline occurs because they are determined by the initial investment and the
depreciation schedule. As EBITDA increases from inflation, the tax shields will become
smaller in relative terms and decline in value in real terms.
5. Real forecasts are important to have because they can be adjusted for changes in inflation
forecasts; however, the nominal forecasts produce the actual cash flow measures needed
for decision making.
6. The five steps are (1) forecast real operating performance by converting historical
financial statements to real terms and projecting forward, (2) derive forecasted nominal
statements from the real projections, (3) build financial statements in real terms by
including real-terms taxes on EBITA, (4) forecast FCF in real terms, and (5) estimate
DCF value in real and nominal terms.
7. The reason ROIC needs to increase more than inflation is that invested capital and
depreciation do not grow with inflation immediately. Furthermore, the amount of
required new investment increases with inflation, and the FCF declines.
8. The problem with a high-inflation environment in this case is that the stock of current
inventory will not reflect its replacement value. In the following scenario, the firm buys
inventory, sells it during the year, and collects at the end of the year. The firm adds a 10
percent markup, and the inflation rate is 20 percent. Assuming the markup is averaged
over the year, if the firm buys inventory for $100 and sells it in four equal installments,
the prices will be $28.60, $29.70, $30.80, and $31.90. The revenue, when collected at the
end of the year, will be $121. If the firm increases inventory to 90 percent of this value,
reflecting the policy of a 10 percent markup, the nominal investment will be $110. To

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purchase the same real amount of the good, however, the new investment should be $120
of the good. Thus, a $110 investment would mean that the firm will be purchasing less
physical inventory. The firm will have to increase its investment in inventory to sell the
same amount the next year. Also, the pretax profit at the end of the year will be only $21,
but the inventory replacement cost will be $120. The after-tax cash flow will be negative.
9. LIFO provides a better estimate of costs during periods of inflation and deflation.
However, if the inflation is very high, LIFO may still underestimate replacement costs.
FIFO is useful for allowing income to be higher during periods of inflation, but there will
be a higher tax expense. If the goal is to better represent the value of inventory, FIFO is a
better method because the book value of inventory will be closer to its market value.

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