In the curriculum page 71 of Corporate Finance, it is written
“A company invests in depreciable assets, financed partly by issuing fixed-rate bonds. If inflation is lower than expected, the value of the real tax savings from depreciation and the value of the real after-tax interest expense are both reduced”
So it seem that both points in this statement are wrong.
Can someone explain why, I am not too sure about the line of reasoning in this one ?
Let’s say you earn $100 every year, and those earnings adjust with inflation. Let’s say your depreciation expense is fixed at $5 every year. 20 years from now, depending on inlfation you could be earning either $110 or $200. If you are earning $110, you pay taxes on $105 in earnings and you save 4.5% on taxes due to depreciation tax shield. If you are earning $200, you pay taxes on $195 in earnings and you save 2.5% on taxes due to depreciation tax shield. So, the relative tax shield of depreciation has reduced.
As for the fixed rate bond, very simply, if i am paying $10 in interest payments every year for the next 20 years, i want that $10 to be worth as little as possible every year going forward, so the higher the inflation the better for me.
I encountered the same question as stated in the original post yet can not make sense of the answer, can someone help me break it down?