Effect of Expected Inflation on depreciation tax savings

CFA Level II
#1

I can’t quite understand this concept.

If inflation is lower than expected, the value of depreciation tax savings and the value of the real after tax interest expense will increase.

Can someone please explain this idea to me?

I understand that the NPV of a project should be higher due to lower nominal discount rates, but how exactly does this tie in with depreciation?

#2

anyone got an idea?

#3

Yes, I guess.

When inflation is rising, the real value of depreciation tax savings will be less because the $$ saved will be less worthy (assuming straight line depreciation over a period and the tax savings from Dep is constant).

Also the value of interest expense which is fixed (assuming interest rate and debt level is same) will be better for corporate and bad for bond holder in rising inflation because of lower purchasing power.

I hope that helps!

#4

Inflation is incorporated into the discount rate for the project. The discount rate accounts for expected inflation. So if inflation is higher than expected, the discount rate really should have been higher and the project NPV should have been lower.

#5

Thanks guys. makes more sense to me now.