Impact of steady predictable inflation on equity holder returns and potential losses

Unexpected changes in inflation/deflation can create real short-term hardships for companies and reduce equity returns. One might expect that steady, predictable inflation would have little impact on a company’s real (i.e., “inflation-adjusted”) equity returns. It is reasonable to think that, even as inflation is raising a firm’s costs, it also is proportionately raising the price the firm can charge, thus leaving its real profits unchanged. In this paper, we mathematically show that for leveraged firms, equity-holder returns may be reduced by inflation even if the inflation is steady and predictable and even if the inflation-adjusted cost of borrowing is unchanged. We show that a high inflation environment reduces firm leverage through the “Tilt Effect” if firms are unable to easily obtain additional credit to maintain their leverage. This reduced leverage reduces equity-holder returns and increases equity-holder losses substantially should the firm fail.