The Irrelevance of Capital Structure for the Impact of Inflation on Investment

Authors

  • SHALOM HOCHMAN,

  • ODED PALMON

    Search for more papers by this author
    • Department of Finance, University of Houston and Departments of Economics, University of Houston and Haifa University, respectively. We thank Robert Heinkel for his comments and suggestions and Michael Brennan for editorial comments. We are indebted to Jeff Callen, Paul Horvitz, Thomas Mayor, Rich Pettit, Ramon Rabinovitch, and other participants of a seminar at the University of Houston for helpful comments.

ABSTRACT

Studies concerning the effect of inflation on firms' investment decisions suggest that the form of financing is relevant in assessing the effect of inflation on investment. This paper demonstrates that when the equilibrium relationship between market rates of return on bonds and stocks is considered, the effect of inflation on investment is independent of the capital structure. The paper also shows that when the ‘Fisher effect’ is assumed to hold, the cut-off rate of return on investment declines with anticipated inflation independently of the financing. However, if the real interest rate rises with inflation, inflation may increase the cut-off rate.

Ancillary