Corporate Finance

Folks, i got 2 questions from corp fin 1. I took this out of the CFAI text. it said that if we invest in depreciable asset, and we issue bond to finance it, and it turns out that inflation is lower than expected, value of real tax saving from depreciation + value of real after tax int expense are both increased. Can anybody please explain the logic behind it? 2. I think 2nd question is similary related to 1st. it said that higher than expected inflation increased the corporation real taxes because it reduces the value of he depreciation tax shelter. Same question, can anybody please explain the logic for this? Thanks

  1. For an asset - You bought it for a higher price than what it was supposed to be. So you are depreciating a higher amount which leads to higher tax savings. For a loan - You took a loan for a higher interest rate than what it could have been. So you are paying a higher interest which leads to an increase in after tax expense. 2. Refer to the first one.

As you prob already know depreciation is an after tax non-cash flow that gets added back when calculating CFO and cash flow for calculating the NPV for capital budgeting projects. Depreciation is based off of expensing assets measured at historical cost. So if inflation is higher than expected the asset is prob worth more now, which in turn would’ve created a higher depreciation expense. So that’s bad when calculating NPV. In regards to interest to bondholders. If actual inflation is higher than expected inflation when the debt was issued, the bondholders understated their required return. So the issuers cost is understated, so as the issuer, that’s good for NPV. Make sense?

Thanks both, a very concise explanation !!