AbstractIn this paper the effect of inflation on firms' investment and debt‐financing decisions is examined. Inflation affects optimal investment and financing directly through the probability of accounting loss and the real value of depreciation and interest tax shields. In addition, when corporate and differential personal taxes cause investment and financing decisions to interact, inflation has indirect effects on these decisions through their interactions. In general, the overall effects of inflation on optimal investment and debt are ambiguous in sign. For tax‐exempt firms, however, optimal investment and debt are independent of inflation. For firms that are always in a tax‐paying position, higher inflation reduces optimal investment without affecting optimal debt. Furthermore, inflation causes total firm value to decrease if the depreciation rate exceeds the firm's debt/asset