Accounting Business Reporting for Decision Making

510 Accounting: Business Reporting for Decision Making

1. Inflation

One factor in the determination of r is inflation. Inflation is the increase in the prices of goods and ser-

vices. The converse is deflation, which often coincides with lower levels of demand in an economy,

periods of high unemployment and economic depression. It has been seldom seen in the developed econ-

omies in the last several decades. Thus, inflation at greater or lesser levels is the norm. What inflation

means for investors is that their invested funds lose purchasing power while those funds are being used

by the investee. Hence, an investor placing $1000 today in any investment and receiving $1000 back in

three years’ time will not recover the same amount of purchasing power. For example, if inflation has

been on average 3 per cent per annum during those three years, then the investor will receive only $915

($1000/1.03^3 ) of purchasing power in today’s terms. In reality, interest rates and other returns offered in

financial markets have an inflation component already incorporated. Thus, the investor does not really

have to worry about this aspect of interest rates and returns. The opportunity return will take care of

the inflationary impact. The reality check ‘Protecting against inflation and deflation’ explains the impli-

cations for investing as a result of inflation and deflation.

REALITY CHECK

Inflation versus deflation

Inflation and deflation are important factors for considering in investment projects. In terms of inflation,

investment strategies such as shares, bonds and commodities such as gold provide a good method of

keeping up with inflationary periods. Property also usually increases in value in inflationary periods. In

terms of deflation, entities can invest in bonds especially government bonds. Shares in industries such

as consumer goods will always compare better than other industries during periods of deflation. How-

ever, if entities do not want to change their investment strategy to meet changes in the economic cycle,

then a good method is to diversify. Blue-chip shares seem to maintain a constant value and also provide

the additional bonus of dividends.