When prices in the market change because of inflation, the market value of an asset changes to reflect the increase (or decrease in a period of deflation). Recall that assets are recorded in a corporation’s books as the value at the time of purchase. A new machine purchased at $25,000 will be recorded at a value of $25,000.
The problem with inflation is not so much the cost of things but buying power. If a person takes a job making $30,000 a year and is still making $30,000 ten years later, the time value of money suggests that this person has lost buying power due to inflation even though the salary remained the same. The nominal amount of money he/she makes is only one aspect of wealth. The effects of inflation combined with the $30,000 will indicate the buying power of the individual. Over the ten years, this individual has lost buying power and is worse off because his/her salary did not increase to keep up with inflation.
Similarly, a machine may be on a firm’s books at $25,000 but because of inflation, the actual value of the asset is constantly changing. The longer the machine sits on the books, the greater the chance the book value and market value of the machine will be different. Even if by some chance the value of the asset after five years was still $25,000 it would be worth less than the purchase price of $25,000 because after five years the value of money is worth less due to inflation.
Inflation can silently erode value when only nominal amounts of money are considered in valuing any asset. Inflation creates discrepancies between book values and market values because the longer an asset sits on the books, the more time inflation has to devalue the dollar. Investors are keenly aware of this phenomenon and are careful to note when assets were purchased. Without an understanding of the effects of inflation on assets, overvaluing of an asset can occur changing the expected returns of an investment.