Expected Inflation and the Constant‐Growth Valuation Model*

In the presence of inflation, the standard Constant‐Growth valuation model found throughout the finance literature is not valid in cases where a company either (1) makes no net new investments or (2) invests only in zero Net Present Value projects. If expected inflation is positive, the generally accepted and widely used expression for the value of the firm under either of these two conditions seriously understates the true value of the firm, even with modest levels of inflation.The authors also show that the Weighted Average Cost of Capital (WACC), as developed by Modigliani and Miller (M&M), will be misleading if inflation is positive. They provide an adjustment factor that corrects this deficiency of the M&M model. Finally, the authors show that the WACC formula developed by Miles and Ezzell is correct when the parameters are stated in nominal terms, and therefore no adjustment is necessary.

Duke Scholars

Author Michael Bradley Fuqua School of Business