capital budgeting

CFA Level II
#1

Statement 1: A company invests in depreciable assets fianncial partly by issuing fixed rate bonds. If inflation is lower than expected the value of the real tax savings from both depreciation and the value of the real after tax interest expense are both reducee.

We are asked to evaluate the statement

q: the dtatement is correct regarding the effects on

  1. Tax savings from depreciation but incorrect abt after tax interest expense

  2. Correct abt both

  3. Neither depreciation nor interest expense.

Correct answer is 3. The exaplanation is both shld increase. Depreciation savings should go up which I understand but as an issuer if I am paying cash flows to bond holder and my inflation is lower than what I expect I should lose as the issuer and the bondholders would gain because the real value of their cash flow payments has gone up. As an issuer how do I benefit from lower than expected inflation in this case? Not understanding this. Pls help

#2

Hi guys if anyone can answer that would be highly appreciated.

#3

Depreciation is fixed, as are the coupon payments on the bonds.

Higher inflation decreases the real value of fixed payments, and lower inflation increases the real value of fixed payments. Both would therefore be increased if inflation were lower than expected.

#4

S2000- many times I feel stupid for not reading the question/overcomplicating it and then I read your response and my reaction is #facepalm. thank you as usual.

#5

You’re welcome.

And you’re not alone.