Impact of Inflation on Profitability

IMPACT OF INFLATION ON PROFITABILITY OF A PHARMACEUTICAL SECTOR IN PAKISTAN

BY MOAZZAM BAIG

A thesis is submitted in partial fulfillment of the requirements for the degree of master in business administration to Iqra University Research Center (IURC) at the Iqra University Quetta Campus.

Quetta, Pakistan JANUARY 20, 2013 TABLE OF CONTENTS

Impact of Inflation on Profitability S.no 1. DESCRIPTION CHAPTER 1: INTRODUCTION

1. Back ground of the Study/Problem.. 2. Statement of the study/ Problem.. 3. Objective of the Research 4. Research hypothesis/ Question 5. Theoretical Framework 6. Definition of the terms. 7. Limitation of the Study 8. Significance of the Study

PAGE NO 1 1 1 2 2 2 2 2

2.

CHAPTER 2: REVIEW OF THE RELATED LITERATURE

1. Buyer Cost. 2. Monitoring the external environment .. 3. Profit and business costs..

7 8 8

3.

CHAPTER 3: RESEARCH METHODOLOGY

1. Research Design.. 2. Source of Information(URL). 3. Target Population . 4. Sample Size 5. Sampling Technique.. 6. Description of the analysis technique ..

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4.

APPENDICES

CHAPTER 1: INTRODUCTION 2

Impact of Inflation on Profitability

1.1 Back ground of the Study/Problem.

Today, inflation is one of the serious problems faced by Pakistan. Inflation rate in Pakistan is very high. According to economic survey 2009-10, its rate is 13.3 %, while it was 22.3 % in last fiscal year. According to ESP (Executable Streaming Price) rate of inflation (CPI) is 14.1%. By definition inflation is a state in which prices rise and money value decreases. Due to inflation the real value of money i.e., the purchasing power decreases, which directly affects the profitability of any sector. Hence its a crucial issue to discuss how badly inflation affects the economy of country by taking in view of any sector. This sector could be a right representative of population to study. Inflation is everywhere in an economy. Its rate is high in developing countries and is low in developed counties. By making effective operation of monetary and fiscal policy is essential to control the inflation.

2.1 Statement of the study/ Problem.

The impact of Inflation on Profitability by making a sample of listed Companies of pharmaceutical Sector in Pakistan. In the corporate finance, the Profitability is considered as one of the most important issues. The main purpose behind the study is Profitability which considers the most important issue for the present firms to earn profit due to market dynamics. Profitability is encouraged by several other factors such as the future investment opportunities and future cash flows and these opportunities are suitable for the company when economic indicators plays the positive role in a country.

3.1 Objective of the Research.

The primary objective of this research is to study the impact of Inflation on profitability of a pharmaceutical sector in Pakistan. The secondary objective of our study was to assess the empirical validity of value-based relationship between inflation and profitability for a sample of Pharmacy Industry. The principal objective of the analysis should be to provide the Board of Directors with the basis for a continuous review of their strategy for survival of Business. 4.1 Research hypothesis/ Question

Impact of Inflation on Profitability There is Significance relationship between inflation (SPI, CPI &WPI) and Profitability (GPM, OPM & NPM) of a Pharmaceutical Sector. 2.3 Theoretical Framework
The purpose of the present paper is to examine the observed and value-based models for a Sectors Profitability. Inflation is an important issue in Pakistan. Many economists explain the effect of Inflation on the economy of a company. Many economists are of the view that Pakistan should reduce the Inflation such as the indexes of CPI, WPI and SPI because inflation affect negatively on consumer purchasing power and it ultimately affect the profitability of a company. It is generally found that increase in the rate of Inflation often decrease the demand of the product, because product become expensive that effect not only the sales revenue of the company but it also effect the net profit of a company. By presenting the theoretical significance with value-based data its validate the predicted relationships between profitability and inflation.

Inflation rate

Profitability (GPM, OPM & NPM)

(SPI, CPI &WPI)

Independent Variables

Dependent Variable

2.3 Definition of the terms. Profitability, Inflation, CPI, WPI, SPI, listed companies and ESP. 2.3 Limitation of the Study.
The research is limited up to pharmaceutical sector of Pakistan with a limited number of fiscal year data which is covered regression technique. While consider all other factors has a constant effects on a profitability. Further research can be conducted by investigating the profitability of numerous Sectors and may include the other predictor to seek the impact on profitability.

Impact of Inflation on Profitability 2.3 Significance of the Study.

Inflation can lead to uncertainty about the future profitability of investment projects (especially when price variability is also associated with high inflation rate). This leads to more traditional investment strategies, ultimately leading to lower levels of investment and profitability. On the other hand profitability may also Increase a countrys international competitiveness, by making its exports relatively cheaper, thus impacting on the balance of payments. Moreover, Profitability can interact with the tax system to flatten borrowing and lending decisions. Firms may have to devote more resources to dealing with the effects of inflation.

Impact of Inflation on Profitability

CHAPTER 2: REVIEW OF THE RELATED LITERATURE In this paper the impact of inflation on company liquidity and profitability during 2001and 2011 is summarized and some implications of this operational research help the Board of director for executing financial strategies through out the year. However Inflation and cost of doing business are the crucial factors that influence the corporate profits, which ultimately lead to business failure or liquidation. A general economics literature, both theoretical and empirical, examines the micro-foundations of the links between inflation and price. In particular, several articles based on rational expectation theories of the relationship between inflation and price form the basis for the tests in this paper. In contrast, little research has been done on how inflation affects profit margins. The accounting profession has spent a lot of time examining how inflation affects a firms financial statements with emphasis on how inflation changes the way companies report revenues and costs. Research on the impact of inflation on price distribution generally focuses on imperfectly competitive markets. Two distinct aspects of inflation have been studied as the possible cause for price distribution. These are expected inflation (the mean) and inflation uncertainty (the variance). Sellers menu costs and buyers search costs in an environment of imperfect information have figured prominently in this literature. Relevant theoretical models are Sheshinski and Weiss (1977), Benabou (1988, 1992a, 1992b), Benabou and Gertner (1993), Diamond (1993), Van Hoomissen (1982) and Tommasi (1994). Each of these models constructs inflation as a shock to the supply function.

Impact of Inflation on Profitability Sheshinski and Weiss (1977) study a monopolistic firm that faces a cost for adjusting its selling price. The seller optimally follows an S,s pricing rule in an inflationary environment. He will maintain a constant nominal price until inflation erodes his real price below s, and then he will increase his nominal price to S. As inflation increases, S increases and s falls; thus the magnitude of a price change increases. Given monopolistic competition, Benabou (1988, 1992a) introduces the idea that the larger and more frequent price adjustments of S,s pricing during inflation offers consumers a scope for search. In equilibrium, consumer search is optimal given the price distribution that results from the staggering of pricing rules. Welfare effects depend upon the size of consumer search costs. Low search costs allow consumers to take advantage of price differences that lead to increased competition and positive welfare effects. High search costs imply even greater equilibrium prices and more price distribution. The wasteful search costs and higher prices have negative implications for welfare. Diamond (1993) follows a similar strategy, but develops his model with sticker prices. Prices are literally affixed to the good itself. The sticker can only be changed at some cost. Inflation reduces the real price of a sticker product sitting in inventory. The presence of the older priced goods lowers the reservation price of the consumers. Inflation actually reduces market power because consumers search for goods with the old sticker price. There is price distribution, but less market power. Only a few theoretical papers touch on the issue of how inflation affects profit levels. This work follows Lucas (1973) and studies the impact of inflation uncertainty on price markups, which affects the profitability. Benabou and Gertner (1993) introduce a stochastic shock on the costs of producers and examine the effect of inflation uncertainty on price distribution. In this model, consumers cannot distinguish between aggregate and relative shocks. Consumers can decide to enhance their information with search and must infer

Impact of Inflation on Profitability from prices whether it is worth the cost to search. Benabou and Gertner find increased inflationary uncertainty has two effects on welfare. First, there is a correlation effect. If seller prices are correlated, inflation makes consumers search less when they observe a high price. However, consumers search more when they observe a low price because they believe better prices may be available. Second, there is a variance effect. Because buyers can return to the first seller costlessly, an increase in inflation uncertainty increases the option value of search. Increased inflation uncertainty promotes search and lowers the sellers market power. Benabou and Gertner show that increases in inflationary uncertainty lead consumers to seek more information. In equilibrium, consumers are better informed and prices adjust to the increase in competition. The main result of Benabou and Gertner (1993) is that the effect of inflationary uncertainty on market efficiency depends critically on the magnitude of buyer search cost. Low search costs make it possible that the benefits from an increase in inflation uncertainty outweigh the costs. Increased price competition may result in a benefit that is higher than the buyers search cost. High search costs lead to the opposite result. An increase in inflationary noise allows sellers to charge higher real prices as they take advantage of the consumers reduced information. Thus, high buyer search costs imply higher firm profit margins and decreased efficiency. Van Hoomissen (1982) and Tommasi (1994) show that inflation lowers the in formativeness of current prices about future prices. Prices become outdated quickly, which leaves the consumer less well informed. Van Hoomissen finds the reduction in the consumers information stock leads to greater price distribution and provides empirical evidence to support her findings. Tommasi shows that the lower information stock translates into higher consumer reservation prices. Repeat purchase consumers thus have less incentive to acquire price information. Less well informed consumers permit firms to raise their markups which results in price distribution. The empirical literature on inflation and price distribution generally supports the above theoretical papers, but there are some exceptions. Weiss (1993) provides an

Impact of Inflation on Profitability excellent survey of empirical findings from microeconomic data on the issue of inflation and price adjustment which leads to profitability. Two empirical regularities are generally recognized. First, nominal price changes occur in discrete jumps. This is clearly consistent with pricing theory. Second, as inflation increases, the variance of relative prices (price distribution) also increases. This supports all of the aforementioned theoretical models. Reinsdorf (1994) does dispute the findings of the previous empirical literature. Reinsdorf studies food prices and finds that inflation and price distribution are negatively related. He claims his results support the theory that unexpected inflation induces more search because inflation reduces the consumers information stock about price distributions. However, it does not seem that Reinsdorfs findings are as inconsistent with previous theory as he claims. Search costs in the grocery store are extremely low and comparisons are easy. As previous theory would suggest, low search costs likely increase competition that would account for Reinsdorfs results. Empirical literature on the impact of inflation on gross margin or profit levels is as sparse as is theory. Benabou (1992b) studies inflation and markups in the U.S. retail trade sector. He finds expected and unexpected inflation has a small but significant negative effect on retail markups. Benabou interprets his findings as support for the prediction that pricing theory under inflation would lead to higher price distribution. With low consumer search costs, price distribution promotes search and competition intensifies leading to a decrease in markups. Kaskarelis (1993) finds much the same result for the UK manufacturing industry. Borenstein, Cameron, and Gilbert (1997) document asymmetric gasoline price responses to crude oil price changes and argue that the data is not inconsistent with the implications of the Benabou and Gertner model. In gasoline markets, increases in inflation uncertainty do translate into higher profit margins. 2.3 Buyer Cost Previous empirical studies have found a negative relationship between inflation and industry profit margins. Recent theoretical findings, however, suggest that

Impact of Inflation on Profitability buyer search costs can significantly impact this relationship. We use an actual measure of search cost that varies across wholesale industries to estimate the impact of these costs on the relationship between inflation and markups. Using firm-level data from 57 industries, we show that margins increase during inflation if search costs become sufficiently high. Our findings reconcile the theoretical and empirical literatures on this topic. 2.2 Monitoring the external environment It is important that companies are able to adapt their strategy and operations and respond quickly to changes in the external environment. This implies the need to anticipate and monitor such changes. Every company should therefore carefully monitor, in this country and overseas, the national and industry statistics produced by international organizations, government departments, trade associations, and forecasts made by econometric forecasting units such as the National Institute for Economic and Social Research Forecasting Unit. At the industry level it is important to recognize that the rapid rate of inflation and the fundamental changes arising from the oil price increase and the energy crisis, and the changing pattern of income distribution, may have led to changes in the pattern of demand so as to make past indicators of future industry demand unreliable. 2.3 Profit and business costs Its a common phenomenon in business life, when Cost of doing business is rise will also make a decrease in profits. Taxation is an other core issue that indirectly influences the profitability. This research is especially focus on the income statement items that deals with corporate profits in relation with the economic indicator i,e. inflation. If sales revenue increases it may the cause of high cost incurred during the period. So here we measure profit through three different profit margins and seek the impact of inflation on it. Although expected inflation seems to have a negative effect on subsequent stock returns, and discourage the investment opportunities in any sector in the country. The negative relationship is further proved by many researchers. The board of

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Impact of Inflation on Profitability director can take a quick look on the current economic indicators to forecast the trend for there business.

CHAPTER 3: RESEARCH METHODOLOGY

1. Research Design.

Profitability Dependent Variable

Gross Profit margin(GPM) Operating profit margin(OPM) Net profit margin(NPM)

Inflation Independent Variable

CPI WPI SPI

2. Source of Information(URL) Pakistan bureau of Statistics. Stat Bank of Pakistan. International Monetary Fund. Karachi Stock Exchange. Trading Economics.

3. Target Population The Listed companies of Pharmaceutical sector in Pakistan. 4. Sample Size A sample of 9 companies of Pharmaceutical sector listed in Karachi stock exchange and collected annual data from the period of 2001-2011.

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Impact of Inflation on Profitability

5. Sampling Technique In this thesis we use the convenience sampling technique because our population is infinite we dont have access to the data of more than 10 years in Financial highlights so we have taken data of from 2001-2011 and took 9 companies of Pharmaceutical industry listed on Karachi stock exchange which are true representative of population. In this way we have got 99 observations which are sufficient to apply regression technique. 6. Description of the analysis technique The analysis utilized Simple Linear Regression. The most basic test involved regression of the dependent variable net profit against the independent variable Inflation. This provided a basic test of the relationship between profitability and Inflation. The following regression was adopted: GPMy1+NPMy2+OPMy3= + x+ et Where Is the value of the dependent scale variable GPM= Gross profit margin, Y1,2,3 NPM= Net profit margin. OPM=Operating profit margin. is the value of the coefficient, is the value of the predictor Inflation Constant Error Term The expectation was that the Inflation is negatively related with Profitability. That is, increases in Inflation decrease the profitability of a company.

x et

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Impact of Inflation on Profitability

APPENDICES Benabou, Roland. Search, Price Setting and Inflation. Review of Economic Studies, July 1988, 55(3), pp. 353-376. Benabou and Gertner, Robert. Search with Learning from Prices: Does Increased Inflationary Uncertainty Lead to Higher Mark-Ups? Review of Economic Studies, January 1993, 60(202), pp.69-94. Diamond, Peter. Search, Sticky Prices and Inflation. Review of Economic Studies, January 1993, 95(3), pp. 547-566. Kaskarelis, Ioannis A. Inflation and the Mark-Up in UK Manufacturing Industry. Oxford Bulletin of Economics and Statistics, November 1993, 55(4), pp. 391-407. Lucas, Robert E. Some International Evidence on Output-Inflation Tradeoffs. American Economic Review, June 1973, 63(3), pp. 326-334. Reinsdorf, Marshall. New Evidence on the Relation Between Inflation and Price Distribution.American Economic Review, June 1994, 84(3), pp. 720-731. Sheshinski, Eytan and Weiss, Yoram. Inflation and Costs of Price Adjustment. Review of Economic Studies, 1977, 44, pp. 287-303. Tommasi, Mariano. The Consequences of Price Instability on Search Markets: Toward Understanding the Effects of Inflation. American Economic Review, December 1994, 84(5), pp.1385-1396. Van Hoomissen, Theresa. Price Distribution and Inflation: Evidence from Israel. Journal of Political Economy, December 1988, 96(6), pp. 1303-1314. Weiss, Yoram. Inflation and Price Adjustment: A Survey of Findings from MicroData. In Optimal Pricing, Inflation, and the Cost of Price Adjustment, edited by Eytan

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Impact of Inflation on Profitability Sheshinski and Yoram Weiss, pp. 3-17, The MIT Press, Cambridge, Massachusetts, 1993.

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