Impact of higher inflation on cost of capital

PrintMailRate-it

published on 20 February 2024 | reading time approx. 5 minutes


Inflation has a complex impact on the valuation of companies. The cost of capital is made up of several parameters that react individually to inflation. It is important to understand the impact on each parameter and to treat them with the utmost care in order to get a clear picture of the overall impact on the company's valuation. It is important to note that the appraiser has varying degrees of latitude with respect to the cost of capital parameters.



Impact of higher inflation on cost of capital

As a result of the COVID-19 pandemic and the Russian war of aggression, Europe has experienced a surge in inflation. Inflation has a complex impact on company valuations. Valuers are faced with new challenges amidst the turmoil of uncertainty caused by value chain disruptions and geopolitical conflicts. In a DCF model common­ly used by business valuators, the cost of capital plays a key role in determining the value of a business. The cost of capital is made up of several parameters that are individually sensitive to inflation. It is important to understand the impact on each parameter and to treat them with the utmost care in order to get a clear picture of the overall impact on the valuation of the company.

The WACC approach is a common method for determining the weighted average cost of capital, where each category of capital (equity and debt) is weighted proportionally:

WACC = (R_f + β*MRP) * E/EV + k_D * (1 – s) * D/EV

R_f: Risk-free interest rate (base rate)
MRP: Market-risk premium
β: Beta-factor
k_D: Cost of debt
D/EV: Share of debt capital
E/EV: Share of equity
s: Tax rate

In a DCF WACC method, the WACC is also used as the capitalisation rate in calculating the terminal value:

Terminal Value = Cashflow * (1+g) / (WACC-g)

Where g is the sustainable growth rate.

The valuation parameters are detailed below:


Risk-free interest rate (base rate)

In accordance with the German IDW S1 valuation standard, the Svensson method is used to derive the discount rate. The calculation is based on Deutsche Bundesbank data for German government bonds. Rising inflation or inflation expectations, as well as monetary policy measures to combat inflation, lead to rising bond yields and are subsequently reflected in a higher base rate. Due to the standardised process for determining the base rate, the appraiser has no ability to adjust in a high inflation environment.


Market risk premium

The market risk premium is calculated as the difference between the market return and the base rate. There are two basic ways of determining the market risk premium. The first is based on historical realised market returns and the second is based on analysts' expectations of future market returns, the so-called implied market return. In contrast to the historical approach, implied market yields reflect rising inflation expectations. The following chart shows that the rise in inflation expectations in 2022 and 2023 is also reflected in the implied market yield, in addition to increased geopolitical risks.

 
Sources: Analysis Rödl & Partner, Capital IQ, Deutsche Bundesbank

The increase in market yields is greater than at the beginning of the pandemic, which was also accompanied by considerable uncertainty. In addition, the market yield is consolidating at a higher level. The valuation standard setters in Germany (Institut der Wirtschaftsprüfer, IDW) and Austria (Kammer der Steuerberater und Wirt­schafts­prü­fer, KSW) publish recommendations for determining the market risk premium. The IDW last in­creased its recommendation for the market risk premium in 2019 and did not change it in 2022 due to the increase in long-term inflation expectations. This is also due to the fact that, unlike the KSW, the IDW does not recommend a market return, but rather a market risk premium. Due to the increase in the key interest rate, the market risk premium was more stable compared to the market yield. In Austria, on the other hand, the Expert Committee for Business Administration published an application note on the determination of the market risk premium in October 2022. The expert committee refers to the rise in long-term inflation expectations and the associated increase in implicit market yields. It also states that this situation may make it appropriate to deviate from the upper limit of the recommended range for the market yield (currently 7.5 - 9.0 percent). The Austrian standard setter thus allows the valuer to react to the long-term increase in inflation expectations when determining the cost of capital. In contrast to the prime rate, the standard setter's range gives the valuer limited leeway in determining the market risk premium. In determining the latter, the valuer must take into account the expected level of inflation.


Beta-factor

Beta is a measure of the volatility of a company's return relative to the market as a whole. The impact of rising inflation will be different for each company and must be assessed on a case-by-case basis.


Debt beta

The debt beta is calculated by dividing the credit spread by the market risk premium. The credit spread is defined as the difference between the expected cost of borrowing and the federal funds rate. High inflation leads to higher borrowing costs and a higher base rate. However, this does not mean that the credit spread will remain unchanged. In 2022 and 2023, borrowing costs rose more than the base rate, leading to an increase in credit spreads. However, as inflation also affects the market risk premium, the overall impact on the debt beta must be considered on a case-by-case basis and depends on the specific asset being valued.


Share of debt capital

Rising interest rates on debt resulting from higher inflation lead to a loss in the real value of fixed rate debt. A decline in the market value of debt, other things being equal, leads to a higher weighting of the cost of equity in the weighted average cost of capital.


Equity share

Because of the variable rate of return on equity, rising inflation expectations are not necessarily associated with a loss in real value. Firms with the ability to pass on price increases are able to maintain their real cash surpluses. Since the proportion of debt tends to fall with inflation due to the loss in real value, the proportion of equity rises accordingly. However, limited price pass-through can have a significant impact on the value of equity, so the situation may be different in individual cases.


Tax rate

There is no direct correlation between the level of the tax rate and inflation expectations.


Rate of sustainable growth

The sustainable growth rate depends in particular on the long-term level of inflation in the relevant economic area and the ability to pass on rising costs.

An initial starting point for the sustainable growth rate can be the general level of inflation according to IDW S 1. However, the current (actual) level of inflation based on a consumer price index cannot be used here; instead, the long-term inflation expectation must be taken into account. This can be determined using the break-even inflation rate (the current yield differential between fixed-rate and inflation-indexed bonds) or inflation swaps. The following chart shows actual inflation based on the Harmonized Index of Consumer Prices (HICP) com­pared to long-term inflation expectations. Long-term inflation expectations were calculated as an average based on the 10-year break-even inflation rate for German government bonds and the 10- and 30-year zero-coupon inflation swap for Germany.

 
Sources: Analysis Rödl & Partner, Bloomberg, Statistisches Bundesamt

Long-term inflation expectations averaged 1.7 percent between 2014 and 2019, often below actual inflation. As a result of the pandemic, long-term inflation expectations fell to 1.2 percent in 2020. In the following years, the rise in actual inflation is accompanied by a rise in inflation expectations. From 2022 onwards, long-term in­fla­tion expectations average more than 2.5 percent. However, the chart also shows that inflation must be strictly separated into actual (short-term) and expected long-term inflation. The latter has a higher weighting in the derivation of the cost of capital.

Valuation must take into account not only the expected inflationary environment, but also the ability of the subject of the valuation to increase its cash flow. It is important to examine the pricing power of the company in the market. A company with stronger pricing power can pass on inflation to its customers. Key factors include the cost structure and quality, the cost-to-sales ratio, and the competitive situation.

By combining long-term inflation expectations and company-specific factors, the sustainable growth rate can be determined.


Conclusion

Rising inflation or inflation expectations have different effects on the cost of capital parameters. High inflation generally leads to a higher risk-free rate, a higher market risk premium and a higher sustainable growth rate. The impact on the beta factor must be assessed on a sector-specific basis. Although credit spreads tend to widen adjustments and estimates must be made to determine credit spreads. As the market risk premium also increases, the overall impact on debt beta is unclear. Assuming that equity grows in line with the market in an inflationary environment, the proportion of debt tends to fall and the proportion of equity rises accordingly. Overall, in a high inflation environment, market participants' yield requirements increase and the cost of capital rises as a result.

For some of the valuation parameters (benchmark interest rate, beta factor, credit spread), the determination is fixed by a valuation standard or valuation practice. In contrast, the appraiser has limited latitude in determining the market risk premium and the sustainable growth rate. The appraiser must ensure that all valuation pa­ra­me­ters and the relationships between them are consistent. Extensive knowledge and experience in business valua­tion are essential to meet this challenge.

Deutschland Weltweit Search Menu