“How would a higher than expected inflation rate affect the value of the real tax savings from depreciation and the value of the real after-tax interest expense, everything else held constant?” A. real tax savings from depreciation and real interest expense would be lower. B. real tax savings from depreciation would be higher and real interest expense would be lower. C. real tax savings from depreciation would be lower and real interest expense would be higher. I answered A, but I don’t know why the answer is B.
Ya that doesn’t look right.
A should be the answer, which was verified by my Stalla guide. A reduces the value of the depreciation tax shield. Why? Because you could have bought the same asset at a higher price and recognized greater depreciation expense. I’m not too sure about the interest rate scenario, but the guide states the real interest expense would decrease.
If inflation is higher than expected, profitability of the investment is correspondingly lower and increases the corporations real taxes because it reduces the value of the depreciation tax shelter. That’s straight from the horses mouth.
please refer to errata
thx guys for clearing it up. it was taken from the last Q on Corp Finance in CFAI text. I think the answer was talking about real taxes instead of tax savings.