The Zero Growth Model with Expected Inflation: Further Insights: A Consistent and Inflation Neutral Formulation for the Cost of Equity

Abstract

The Constant Growth Model attributed to Gordon (the Gordon Model) is one of the most known and popular models in Corporate Finance. In this work we show that even with adjustments in the calculation of the proper Weighted Average Cost of Capital, WACC, in order to grant that the model with zero real growth and inflation is inflation neutral it has some inconsistencies. We develop a formulation for Ke, the cost of levered equity that is consistent and is inflation neutral. We identify problems of consistency and non inflation neutrality when using the Weighted Average Cost of Capital, WACC.

Keywords: Constant Growth Model, perpetuities, Terminal Value, cost of equity for perpetuities, tax savings

JEL Classification: G12, D61, G31, H43