a. Demonstrating the Relation between Borrowing, Inflation, and Asset Lifetime
Assuming:
r = rate of inflation (10% inflation = 10)
n = number of years of useful asset life
B = necessary minimum percentage of financing by debt
The ideal percent of debt financing depends on inflation and asset life.(1 + r)n - 1
Then: B = —————————
(1 + r)n
The following Figure 1 shows the results of this equation in graphic form for assets with different lifetimes. The X-axis represents the inflation rate, and the Y-axis represents the percentage of the original asset cost that should be borrowed to allow replacement. From these curves it is quite obvious that the longer the life of the asset and the higher the inflation rate, the more debt is required to be able to finance replacements without penalizing the owners with recapitalization investments.
The life of the asset defines the time span of monetary decay. The inflation rate defines the rate of decay. We must still keep in mind that the borrowing capacity of a company is limited and that inflation is not controlled by the management of the firm.
The asset life becomes a key element in planning for survival with inflation. The higher the inflation rate, the shorter the useful life of a major depreciating asset has to be. Management must take this into account, not only when an asset is purchased but already in the early stages of conceiving the specifications for engineering and design.
Figure 1: Percent of Investment to Be Borrowed
This figure allows you to locate the existing inflation rate on the X-axis and to locate your maximum borrowing power on the Y-axis. The coordinate falls on a curve that identifies the sustainable average useful life of the assets to be used in your venture.
Assuming 10% inflation and your borrowing power is limited to 60%, then the maximum average life of the asset you employ in your venture cannot exceed 10 years if you want to be financially able to replace the asset at the end of its useful life.
Conversely, assume that the useful life of the asset has already been decided upon. Locate the existing inflation rate on the X-axis and draw a vertical line until it crosses the curve that represents the coordinates for that decided-upon useful life. Draw a horizontal line from that crossing point to the Y-axis to find out what percentage you need to borrow to beat the inflation problem when you have to replace the asset.
About the Author
Hugo Daems studied law, politics, and business in European colleges and universities. He also holds an MBA degree from the University of California — Berkeley, where he majored in international business and finance. He has had more than 40 years of experience in this field, having held positions as a controller and lead project planner for several major companies. He founded H.E.A.D. CONSULTING Inc. in 1980 and was responsible for the planning and finance aspects of ventures in Europe, Africa, Asia, Central and South America, the Middle East, the South Pacific, the United States, and Canada.
