This question is from Allen resource. Vignette: The management team of PharmCo Inc. is looking at several financing options to continue the growth of the firm. They have hired Dartmouth & Partners to review their current financial situation and recommend viable options. The management team has recently been approached by one of its large shareholders demanding that the company start the issuance of dividends. To date, the company has not paid out a dividend in its 12 years of history. 2003 Summary of Income Statement and Balance Sheet Items (millions) Balance SheetTotal Assets $155.45 Long-term Debt $50.44 Common Stock $32.55 Retained Earnings $4.56 Income StatementSales $73.89 Net Income $3.15 Question: Carlos is also asked to explain how inflation can affect the sustainable growth of PharmCo. Which of the following is the best description of how inflation can affect the firm? a) The effect of inflation will be offset by higher prices since sales will also rise with inflation b) Although inflation is a cost that must be financed, this cost can be paid back cheaper in the future as inflation erodes future dollars used to pay back the present cost c) Since debt is stored in the books at historical cost, increasing inflation will increase the debt-to-equity ratio, thus increasing leverage of firms that carry debt on the balance sheet d) Inflation will erode the value of the company over time if the company grows at a rate less than the sustainable rate --------------- my take is (A) but the answer is © The explaination is "The real problem with inflation is its effect on historical debt. Since debt is valued at cost when it is entered on the balance sheet, increasing inflation will magnify the cost since inflation erodes the value of future dollars, and the original cost of the debt will not fall accordingly. " ----------- I thought Inflation is favor to debtor who can pay the debt later in lower value. anyone here can explain the answer frm allen resource??
Inflation is beneficial ‘to debtor who can pay the debt later in lower value’, but that is from an adjusted financial statement perspective. I think answer C is describing this effect, whereby even though inflation is beneficial for debtors, it messes up the D/E ratio from an un-adjusted financial statement perspective.