This document discusses inflation, how it is measured, its impacts on corporate finance, and remedies. It provides definitions of inflation and how it is measured using consumer price index and wholesale price index in India. It then outlines various monetary and fiscal policy measures governments can take to control inflation, and how inflation affects asset valuation, firm value, financial returns, and financial analysis. It concludes by discussing how inflation impacts capital budgeting decisions.

1. Financial Management
Semester II
Batch 2012-15
Title :- Inflation, its Impacts on Corporate
finance & remedies.

2.  Meaning of Inflation
 How it is Measured
 Remedies of Inflation
 Measures to Control Inflation
 Important Fiscal Measures
 Impact of Inflation on Corporate Finance

3.  Inflation is a rise in the general level of prices of goods
and services in an economy over a period of time.
 When the general price level rises, each unit of currency
buys fewer goods and services.
 Consequently, inflation also reflects an erosion in the
purchasing power of money – a loss of real value in the
internal medium of exchange and unit of account within
the economy.
 A chief measure of price inflation is the inflation rate, the
annualized percentage change in a general price index
(normally the consumer price index) over time.

4.  Consumer Price Index (CPI)
Consumer Price Index (CPI) in India increased to 221 Index
Points in January of 2013 from 219 Index Points in
December of 2012. Consumer Price Index (CPI) in India is
reported by the Labour Bureau, Government of India.
Historically, from 1960 until 2013, India Consumer Price
Index (CPI) averaged 54.45 Index Points reaching an all
time high of 221 Index Points in January of 2013 and a
record low of 4.32 Index Points in April of 1960. In India,
the Consumer Price Index or CPI measures changes in the
prices paid by consumers for a basket of goods and
services. This page includes a chart with historical data for
India Consumer Price Index (CPI).

5.  The Wholesale Price Index or WPI is "the price of a representative
basket of wholesale goods. Some countries use the changes in
this index to measure inflation in their economies, in particular
India – The Indian WPI figure was earlier released weekly on every
Thursday and influenced stock and fixed price markets. The
Indian WPI is now updated on a monthly basis. The Wholesale
Price Index focuses on the price of goods traded between
corporations, rather than goods bought by consumers, which is
measured by the Consumer Price Index. The purpose of the WPI is
to monitor price movements that reflect supply and demand in
industry, manufacturing and construction. This helps in analyzing
both macroeconomic and microeconomic conditions.

6.  The first panacea for a mismanagement nation is inflation
of the currency.
 The second is war. Both bring a permanent ruin. They both
are the refuge of political and economic opportunists.
(Ernest Hemingway).
 To avoid political unrest and harmful, social and economic
effects on the economy, it is the main objective of every
government to take appropriate measures to control
inflation.

7. Monetary Policy
 Monetary policy is a policy that influences, the economy
through changes In the ‘money supply and available credit
Monetary policy is adopted by central bank of a country.
 The various monetary measures which are used to control
inflation are grouped under two heads (a) Quantitative
controls
 (b) Qualitative controls.
 They are (1) Open market operations (ii) Variation in bank
rates (iii) Credit rationing (iv) Varying reserve requirements
(v) Varying margin requirements (vi) Consumer credit
regulations.

8.  Fiscal policy is the deliberate change in either government
spending or taxes to stimulate or slow down the economy.
 It is the budgetary policy of the government relating to
taxes public expenditure, public borrowing and deficit
financing.
 Fiscal policy is based upon demand management i.e.,
raising or lowering the level of aggregate demand by
controlling various expenditures, government expenditure,
consumption expenditure and investment expenditure

9.  Changes in Taxation.
If the govt., of a country brings about changes in tax rates, it
can help in stabilization of prices in the country. For
example, a decrease in taxes rates, increases disposable
income in relation to national income. Hence, consumption
rises at every level of national income. With the increase in
aggregate demand for goods, the employment goes up in
the country.
A rise in tax rates has the opposite effect.
A rise in taxes causes a decrease in disposable income,
creates a larger budget deficit and brings relief from
inflation.

10.  Changes in Govt. Expenditure.
If inflation is at or above the level of full employment in the
country, the government can bring down price level by curtailing
its own unproductive expenditure.
 Public borrowing
Public borrowing is another effective method of controlling
inflation. Public borrowing reduces the aggregate demand for
goods and hence price level.
 Balanced budget changes.
A balanced budget decrease has a mild contractionary effect on
national income and hence on bringing down the price level.
 Control of deficit financing.
For financing the budget deficit, the govt., often resorts to deficit
financing. The bank borrowing and printing of new notes increases
the money supply in the country and pushes up the price level.
Deficit financing therefore, should be avoided to control inflation.

11.  Others Measures:
Apart from fiscal and monetary measures, the other measures
which are helpful in controlling inflation are:
(a) Price support programme
(b) Provision of subsidies
(c) Arrangements of easy availability of goods on hire purchase to
stimulate demand.
(d) Imposing direct control on prices of essential items.
(e) Rationing of essential consumer goods in case of acute emergency
holding of Friday and Sunday markets.
Since 1950’s, the control of inflation has become the chief objective of
both developing and developed countries of the world. The
governments, therefore, take monetary, fiscal and other measures to
combat inflation.

12.  Inflation and asset revaluation
 Inflation and firm value
 Inflation and financial returns
 Inflation and innovation in the financial markets
 Inflation and financial analysis
 Inflation and capital budgeting

13.  In an inflationary period, the book value of assets, typically
reflecting historical cost less accumulated depreciation, do
not reflect their true values.
 Hence it may be worthwhile to consider revaluation of
assets periodically so that the asset values shown in the
balance sheet reflect economic reality more accurately.

14.  If the actual rate of inflation is equal to the anticipated rate
of inflation, the value of the firm remains more or less
unaffected.
 This is so because the anticipated rate of inflation is
properly embodied in the returns expected by the supplier
of capital, the prices expected for the products/services
sold by the firm, the compensation expected by the
suppliers of various inputs, so on and so forth. When the
actual rate of inflation differs from the anticipated rate of
inflation, the firm value is likely to change.
 The impact on firm value depends on several factors:
debtors-creditors position, price-cost responsiveness, and
depreciation and inventory charges.

15.  The expected return on security was defined as the
rate of discount which makes the present value of the
stream of expected cash inflows equal to the price of
the security. Clearly, the expected rate of return was
defined in nominal terms. This implies that the cash
flows are expressed in current rupees, at the time of
receipt and not adjusted for inflation.
 In an inflationary period, the current rupees at the
time of receipt will have lesser purchasing power than
the rupees deployed to buy the security. As a
consequence, the real rate of return on the security
will be less than its nominal rate of return. For eg. If
the nominal rate of return is 15% and the inflation
rate is 10% the real rate of return will be
approximately 5%.

16.  Inflation reduces the purchasing power of money. If the rate of inflation
is, say, 10% p.a, the purchasing power of money declines by 10% p.a. In
such a situation, an income increase of 10%p.a is required to protect
one’s real income. Likewise, if the rate of inflation is 10%p.a, the rate of
return on investment must be at least 10% per year to avoid erosion in
real wealth. To earn a positive real rate of return in a situation like
this, the nominal rate of return must be greater than the inflation
rate, namely 10%.
 In order to cope with inflation, employees seek wage increases related to
consumer price index and business firms include escalator clauses in
supply contracts. What innovations/developments have occurred in
financial markets in response to inflation? The following have been the
important inflation-induced innovations/developments in financial
markets:
 Flexible interest rates.
 Lenders participation in equity.
 Financial futures.

17.  The financial performance of a firm as reflected in
conventionally prepared financial statements (which are
based on historical costs) is influenced partly by
managerial decisions and partly by external
influences, particularly inflation, which are beyond the
control of management. As a result, the performance
shown by financial statements may cloud the economic
performance.
 Inflation may lead to distortions in the inter-firm
comparisons as well. In an inflationary environment, when
historical cost data are used, a firm with older
assets, other things being equal, will show higher rate of
return on assets. This happens because for the firm with
older assets (1) the reported profits are higher as the
depreciation charges are less, and (2) the book value of
the assets is lower.

18.  Inflation has been a persistent feature in the Indian
economy. Hence, it should be properly considered in
capital investment appraisal. In practice, however,
adjustment for inflation is rarely, if ever, made. The use of
current price structure is deemed satisfactory and
reasoning offered runs as follows:
 Inflation is expected to raise the revenues and costs of the
project in a similar fashion. Hence, net revenues after
adjustment for inflation would e equal to the net revenues
in current terms.

19.  The above argument, however, overlooks the
following considerations which cause distortion:
 1. The depreciation charge is based on historical
costs and hence the tax benefit arising from
depreciation charge does not keep pace with inflation
 2. The cost of capital used for investment appraisal
contains a premium for anticipated inflation
 Impact of the following factors on Corporate Finance
 I. Export Incentives
 II. Backward Area Incentives
 III. Mergers & Acquisitions