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January 25, 2022 - A hot topic for a lot of businesses (and the entire economy) right now is inflation. To be prepared to make business decisions in 2022 and beyond, here are the concepts you should be accounting for (both from a macro and micro economic perspective). Let’s start with a couple of obvious ones around costs.
Third Party Costs
The way most everyone experiences inflation is by seeing prices go up (i.e. everything on the dollar menu now costs $1.29). The pandemic created supply chain issues and some goods, like lumber, shot up in price dramatically. Economists in many industries are still figuring out how much of price growth was temporary and will smooth out as supply chains are rebuilt and how much of the growth is permanent and related to inflation. The answer will be different depending on the sectors of the economy and areas of the world. Watching costs for raw materials will continue to be very important in 2022.
Labor Costs
Business leaders surveyed in November 2021 said they plan to dedicate 3.9% more for salaries in 2022 - that’s the largest increase since 2008. This statistic surpasses the original 3% they’d forecasted for 2022 when surveyed back in April. Many of the business leaders (39%) cited inflation as part of why they anticipate the increase.
Wages aren’t the only cost rising around labor though. The cost of replacing a worker is growing fast as the pandemic sparked the Great Resignation and people are reevaluating their work-life balance. It’s estimated to cost between four months and two years worth of salary to replace a worker (depending on their level of expertise). This should inspire a lot of HR departments to evaluate what investments they should make to retain the workers they already have.
Price Elasticity
How large of a price increase will your customers stomach? A lot of businesses will be asking that question as they try to pass on as many of their increased costs as possible - without getting burned. The Consumer Price Index rose 7% in 2021. Consumers may be okay with paying more (even significantly more) for some goods, but not for others. Once a customer changes their behavior it will be hard to get them back.
The Harvard Business Review put out some advice on how to handle a price increase (Tip #1: Call it a price increase and do not use some euphemism like ‘price adjustment’).Macro Level
There are two big unknowns for 2022 that have to be accounted for when considering inflation: what will happen with interest rates and what will happen with taxes.
The Federal Reserve has been aggressive in keeping the economy strong through the pandemic by maintaining lower borrowing costs. Actually, going back to the Great Recession, rates have been at or near 0%. In 2016, they began creeping back up and were at 2.5% when COVID hit. The Fed immediately cut them back to 0% and brought back quantitative easing (where they buy hundreds of billions of dollars in bonds to pump more cash into the economy).
The Fed is watching inflation data closely. In November, they began slowing down their bond buying. They accelerated the slow down in December, and their 481-word press release that month mentioned “inflation” seven times. If they do raise interest rates (as they indicated they expect to) in 2022 that will mean the cost of capital will go up.
If interest rates go up, businesses must evaluate their capital strategies. Is now the time to take out a line of credit with a fixed rate? Should capital that currently isn’t deployed be invested in new opportunities faster? Ultimately, each business needs to understand what is best for them in a higher interest rate environment.
The forecast for tax hikes is less certain. As wages rise with inflation, so will tax collections. But the real impact will come if changes to the tax code get passed into law - which is a big unknown. Lawmakers in Washington are considering a 15% minimum tax for corporations (among other changes).
More than a decade of economic growth and low borrowing costs have resulted in a lot of capital in the economy that could be deployed quickly. Valuations are ticking up as business owners consider exit strategies that they may want to execute before higher tax rates become a reality.
[READ: Why You Need a Business Valuation]
It’s WACC
All of these external factors ultimately come into play when a business is looking at it’s weighted average cost of capital (WACC) to decide whether to borrow, offer equity, or capitalize on an investment or acquisition. The WACC is basically what it costs a company to acquire money and thus also tells it which opportunities it should pursue based on the expected return. It takes into account borrowing costs and taxes - so companies may be reassessing their WACCs multiple times this year.
WACC is a common way to determine the required rate of return through a single number because it accounts for both shareholders’ and debt holders' demand in order to provide capital to the company. This can then be used in discounted cash flow (DCF) and inflation analysis.
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