EFFECTS OF INFLATION ON CAPITAL STRUCTURES AND THE COST OF CAPITAL IN THE 1980 ' s Eugene

Our major conclusions are as follows: (1) If inflation rates remain high, then the yield curve will tend to slope upward more steeply than in the past (or slope downward less steeply when the yield curve is inverted). (2) This yield curve situation will lead firms to shorten the average maturities of their liabilities, even though this will expose them to greater risks of earnings fluctuations or even bankruptcy. (3) The cost advantages to having a stronger financial posture and higher rated bonds will probably increase if inflation remains high in the 1980's. (4) Contrary to .the conventional wisdom of the 1960's and earlier years, the risk premium of stocks over bonds seems to increase as the rate of inflation rises. This suggests that a high and rising rate of inflation might cause firms' optimal capital structures to shift toward more debt and less equity. However, the statistical basis for this conclusion is not strong, and it also is in disagreement with Point (3) above. Accordingly, we are unable to make any strong statements about how inflation affects the optimal debt-equity mix.