Investments, tenth edition

  Inflation and Interest Expense 

 Although inflation can cause distortions in the measurement of a firm’s inventory and 

depreciation costs, it has perhaps an even greater effect on calculation of  real   interest 

expense. Nominal interest rates include an inflation premium that compensates the lender 

for inflation-induced erosion in the real value of principal. From the perspective of both 

lender and borrower, therefore, part of what is conventionally measured as interest expense 

should be treated more properly as repayment of principal. 

 

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7/17/13   4:13 PM

Final PDF to printer

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P A R T   V

 Security 

Analysis

 

Mismeasurement of real interest means inflation deflates the computation of real 

income. The effects of inflation on the reported values of inventories and depreciation that 

we have discussed work in the opposite direction. 

 

 

 Suppose Generic Products has debt outstanding with a face value of $10 million at an 

interest rate of 10% per year. Interest expense as conventionally measured is $1 million 

per year. However, suppose inflation during the year is 6%, so that the real interest 

rate is 4%. Then $.6 million of what appears as interest expense on the income state-

ment is really an inflation premium, or compensation for the anticipated reduction in the 

real value of the $10 million principal; only $.4 million is  real  interest expense. The 

$.6 million reduction in the purchasing power of the outstanding principal may be 

thought of as repayment of principal, rather than as an interest expense. Real income of 

the firm is, therefore, understated by $.6 million. 

 Example  19.5 

Inflation and Real Income 

 In a period of rapid inflation, companies ABC and XYZ have the same  reported  earnings. ABC uses LIFO 

inventory accounting, has relatively fewer depreciable assets, and has more debt than XYZ. XYZ uses 

FIFO inventory accounting. Which company has the higher  real  income, and why? 

 CONCEPT CHECK