Financial management, inflation and the cost of capital : theory and New Zealand empirical evidence

Abstract

Inflation is inextricably intertwined with the key problem of financial management, namely the determination of the cost of capital. In the absence of the cost of capital, investment, financing and dividend decisions are not possible because they are dependent upon valuations which are based on the cost of capital. In inflationary periods, the effects of inflation must be correctly incorporated into the determination of the cost of capital, otherwise financial value is distorted and consequently, purposeful financial decisions which allocate resources in a manner consistent with shareholders' wealth maximisation, is not possible. This thesis seeks to shed more light on the nature of inflation and the cost of capital in the case of New Zealand. In this thesis an overview of the pivotal role of the cost of capital for financial management is presented; the importance of cost of capital is revealed, and the impact inflation can have on the financial acceptability of investment is demonstrated. More specifically, this thesis seeks to reveal the nature of anticipated inflation and unanticipated inflation and utilises the theory of rational expectations, to provide a basis for gaining a better understanding of inflationary expectations. In order to investigate the formation of inflationary expectations of economic agents, and in order to shed light on the necessary adjustments to the determination of the cost of capital, an empirical price equation model following the Barro (1981) approach was developed and applied to New Zealand data. The findings suggest that the estimated Barro model may not be appropriate to explain the formation of inflationary expectations in New Zealand. However, weak empirical evidence of the formation of inflationary expectations, specifically the nature of anticipated and unanticipated inflation, was revealed.