EMG Valuation - Effects of Inflation

Quick clarification on why inflation decreased the value of the firm, from Schweser (Book 3 pg. 135): “The investment in real working capital also increases when the inflation rate increases because the ‘holding period loss,’ increases.” This is confusing to me, can someone explain the interaction between inflation and working capital?

say 100$ was the amount invested in WC. Inflation is increasing. So basket of goods is 1.10 say in Year 1, went up to 1.20 in Year 2. 100 in WC remains the same. Real amount invested in WC =100/1.10 = 90.9

CP, wouldn’t I look at the nominal change in working capital to find the real cash flow effect? That would be 0 adjusted for the inflation, so it would remain 0 and have no effect on the value of the firm. I guess I am confused as to what’s mean by the “holding period loss.”

it is not enough to look at the nominal flow - because there was none. Just by holding the inventory / working capital for a period - it has lost value. You did not use it, but because it lost value, and you needed to maintain it at the level needed from a nominal standpoint (at 100) you had to replenish it. You would have seen this same effect on the multinational operations chapter in FRA - where the Hyperinflationary stuff was discussed. Cash, Accounts Receivable, Inventory (assets) lose value when inflation occurs. Liabilities gain value when inflation occurs (e.g. Accounts Payable).