the company has not estimated the inflation of the replacement cost correctly and the
difference is significant, then the company will have to make mid-cycle adjustments.
(i) Inventory Valuation. Because the references cited concerning the managerial im-
plications of inflation are by U.S. authors, there is a heavy emphasis on using LIFO
for inventory valuation. This is only of significance for U.S. companies and other
companies with U.S. operations, because LIFO is not acceptable elsewhere.
Working with the first year of operations in the hypothetical example, we can see
the difference between FIFO—first-in, first-out—the most used inventory method
outside the United States, and LIFO.
FIFO LIFO- Revenue $115,400 $115,400
- Cost of goods sold ____100,000 ____112,000*
- Profit 15,400 3,400
- Taxes at 40% ____6,160 ____1,360
- Profit after taxes $ 9,240 $ 2,040
- Cash flow (#1– #4) $109,240 $114,040
*Higher because of 12% inflation.
The cash flow from LIFO would be sufficient to pay for the $112,000 replacement
cost of inventory and leave $2,040 available for dividends. Under FIFO, it would not
be sufficient to replace inventory. Every company operating in the United States
whose inventory costs are increasing should use LIFO, but some companies are re-
luctant to report the lower profits after taxes that are a consequence of LIFO.
( j) Dividend Policy. Dividend policy and cash flow analysis are closely linked dur-
ing periods of high inflation. As was evident from the preceding FIFO example, the
company does not have enough cash to replace the inventory that was sold, let alone
consider paying a dividend, even though there were apparent profits.
According to Alfred Rappaport,^10 measurement of distributable cash is a useful
concept in calculating the funds available for dividends in an inflationary environ-
ment. Distributable cash is the maximum amount that the company can distribute to
its stockholders during a period without impairing its operating capability or business
capacity.
Three measurements are required to determine distributable cash:
1.Cash required for increases in costs of productive capacity.
2.Cash required for increases in net working capital.
3.Cash available from increased debt capacity.Since the cash required for increases in net working capital is deducted in deter-
mining cash flow from operations, under the recent FASB statement on cash flows,^11
those companies operating in the United States need only deduct the first and third
items to arrive at distributable cash.
20.5 MANAGERIAL IMPLICATIONS OF INFLATION 20 • 9(^10) Rappaport,Harvard Business Review, January–February 1979.
(^11) FAS No. 95, FASB, 1987.