Q&A: Is capital investment always more profitable in inflationary times?

Is capital investment are always more profitable in inflationary times?

One way of measuring the profitability of an investment project is as a rate of return on capital employed. The real return makes an adjustment for the effects of inflation and it is the expected real return that should drive investment decisions.

‘Inflationary times’ suggests a period when there is a sustained rise in the general level of prices in an economy and perhaps too an acceleration in inflation. If prices of goods and services are increasing year on year and given that capital investment will produce a flow of output over a number of years – does this make investment more profitable and attractive?

The answer is probably not – much depends of course on the rate of inflation but there are good grounds for arguing that higher inflation damages the profitability of investment:

1. Higher inflation might be due to increasing costs of materials, components and other inputs used in supplying products to the market – increased costs damage profit margins

2. Inflationary times will also create pressure for higher wages which, in the absence of offsetting productivity improvements, will cause a rise in unit labour costs

3. Businesses face greater uncertainty at times of inflation – they cannot be sure what is likely to happen to their own costs and also to key macroeconomic indicators such as interest rates and the exchange rate. Businesses are likely to face higher borrowing costs for their loans and overdrafts and higher yields on corporate bonds – all of which will have a negative impact on profitability

4. Higher inflation can cut into the real incomes of consumers leading to a slower growth of demand for goods and services. This risks leaving a business that has invested heavily in new capital equipment with a lot of under-utilised capacity.

5. High relative inflation rates compared to other countries will lead to deterioration in international competitiveness and perhaps a loss of sales in key export markets.

In short rising prices and revenues because of inflation can give rise to an inflation illusion. Businesses might look like they are reaping the benefits of a rise in the general price level, but profitability is essentially down to the costs of production. A low and fairly stable positive rate of inflation can be good news for investment.

High and volatile inflation can be very damaging to the real rate of return on capital investments – this is one of the key lessons from the inflationary decades of the 1970s and 1980s. Equally sustained price deflation can cause difficulties too.