(d) Financial Strategies. Inflation causes an increase in the cost of capital goods,
which can be more rapid than the company’s ability to generate cash flows to replace
the capital goods, particularly machines. The consequences of this situation are any
of the following, alone or in combination: some replacements must be deferred, ex-
ternal financing must be increased, or other uses of funds, such as dividend payments
and discretionary expenses, must be curtailed. Martin V. Alonzo, Vice-President and
Controller of AMAX,^6 suggests the following strategies for beating inflation:
Investment- Explore, buy and develop natural resources and build capital facilities as a hedge.
- Take advantage of recessionary periods and negotiate better engineering, con-
struction and labor contracts. - Be prepared to buy used facilities.
- Look for “buys” in the stock market.
- Forecast higher future selling prices to justify new investments.
Financing- Borrow as much long-term debt as you can for as long as you can.
- In lease–finance transactions, retain residual equipment values.
Operating- Use last-in, first-out (LIFO) inventory valuation method.
- During periods of oversupply increase inventory.
- Negotiate long-term purchase contracts.
- In new technology development, design away from energy-based processes be-
cause of anticipated escalating energy costs. - Measure performance in real terms by converting operating results via use of
GNP deflator and wholesale price index.
(e) Capital Expenditure Evaluations. The traditional discounted cash flow methods
for evaluating capital expenditures, net present value, and internal rate of return have
to be modified in an inflationary environment. There are two aspects to this: consid-
eration of inflation in the cash flow projections and incorporation of inflation in the
required rate of return. In practice, there have been several ways for doing this.
Some companies use nominal dollars based on anticipated inflation in specific
cash flow elements for each year of the project. In this method, an inflation-adjusted
cost of capital is used as the hurdle rate. Other companies select specific elements to
adjust, for example, the amounts of capital expenditures, but use constant dollars to
project cash flows from operations on the premise that cost increases will be offset
by revenue increases; in practice, this is sometimes difficult to achieve. Finally, some
companies project all expenditures and other elements of cash flow in constant dol-
lars and use a cost of capital that excludes inflation. If the inflation rate is high, the
method cited first is preferable.
20.5 MANAGERIAL IMPLICATIONS OF INFLATION 20 • 7(^6) Management Accounting, March 1978, pp. 57–58.