Some Effects of Inflation on a Firm with Original Cost Depreciation

We examine, in a simplified model without uncertainty, the response of a regulated firm to inflation in the cost of capital equipment. This model firm is assumed to be constrained to meet a given demand schedule, and to realize a prescribed rate of return on capital; the firm's revenue requirements include depreciation based on original cost. We explore the steady-state relationships between the firm's financial parameters (rate of return, debt ratio, payout ratio, etc.) and the rate of inflation, which follow by the use of accounting identities from the condition that inelastic demand be met; we also examine the consequences in the steady state of the additional condition that equity investors receive the return they require. We further consider a sudden jump in the rate of inflation, and show that, quite apart from considerations of capital attraction or shareholder satisfaction, this necessitates an increase in the return on capital. We show how, if the firm adjusts to increased inflation only by a gradual increase in its rate of return, holding all other parameters fixed, the necessity of meeting the given demand implies that the old shareholders, who did not foresee an increase in the rate of inflation, will, if regulation is instantaneous and exact, and the required return on equity is earned, receive a real return on their investment which is higher than they anticipated and higher than that received by the new shareholders. This effect can be traced to the use of original-cost depreciation. We then show how by adjustment of any of several parameters, i.e., the payout ratio, the debt ratio, or the balance between internal and external financing, demand can still be met while all shareholders receive exactly the real return they require. The question of whether, in the real world, such an adjustment is possible or desirable is not explored.