An unexpected increase in the rate of inflation will decrease the profitability of an investment. This happens becuase it increases the corporation’s real taxes and reduces the value of the deprecation tax shelter. Can someone please explain the second statement, preferably very simplistically. I know that to get after tax cash flows, you add the depreciation to the NI, then discount all the after tax cash flows to get the NPV. So obviously less depreciation means less ATCF, and smaller NPV. But not seeing the connection with inflation, taxes, and depreciation.
sorry wrong post.
with higher inflation the $ value of the asset is supposed to increase with the price index, but it actually stays the same on the books. depreciation is supposed to be higher but it’s not therefore the depreciation tax shelter is supposed to be bigger but it isn’t
i can live with that answer. thank u.
Let’s try with some numbers. (S-C-D)(1-T) + D Let’s say last year, we had this: (100-25-25)(1-.35) + 25 = 57.5 Now let’s say we have inflation of 10%, which will increase our sales and costs. Depreciation on the other hand, is based on historical book values which (if you’re using straight line) will be 25 again. So now we have: (110 - 27.5 - 25)(1-.35) + 25 = 62.375 So with 10% inflation, we only had about 8.5% increase in cash flow.
whereas if it had been 10% inflation on depreciation as well: (110 - 27.5 - 27.5)(1-.35)+27.5 = 63.25
yes but your cash flow still went up. if there was 0% inflation, your cash flow would only by 57.5 so it seems like you are benefited by inflation here (since 100-25 = 75 but with inflation 110-27.5 = 82.5). am i missing something here
topher Wrote: ------------------------------------------------------- > Let’s try with some numbers. > > (S-C-D)(1-T) + D > > Let’s say last year, we had this: > (100-25-25)(1-.35) + 25 = 57.5 > > Now let’s say we have inflation of 10%, which will > increase our sales and costs. Depreciation on the > other hand, is based on historical book values > which (if you’re using straight line) will be 25 > again. So now we have: > > (110 - 27.5 - 25)(1-.35) + 25 = 62.375 > > So with 10% inflation, we only had about 8.5% > increase in cash flow. but more importantly there was a 15% increase in taxes, where if your depreciation expense had increased along with inflation your taxes would have only increased 10%
(S-C-D)(1-T) + D (100-20-5)(1-.1) + 5 = 67.5 + 5 = 72.5 With 10% inflation: (110-22-5)(1-.1) + 5 = 74.7 + 5 = 79.7 So your profitability went up. Yes, CPK, I agree that if depreciation went up too, your profitabilty would be higher because you’d have (110-22-5.5)(1-.1) + 5.5 = 79.75. However, does this justify saying that a rise in inflation decreases firm profitability because of a decerased tax shield?
if you’re paying more in taxes you’re certainly reduced profitability.
why are u making the conclusion that taxes go up
because the effectively have… see my example
(S-C-D)(1-T) + D so the implication is that with inflation, because sales and costs went up and depreciation did not, your taxes payable have effectively gone up (though your tax rate has stayed the same). In other words, that “first D” is now not able to shield you as much from the tax rate.
the show NY, What you just said is how I understand this concept. It’s not necessarily that profitability was negative, but it did decrease in the sense that inflation eroded your cash flow. If you have 10% inflation, but your cash flow went up only 8.5%, did you become more profitable because your CF went up? No, in actuality, you became less profitable in real terms after accounting for inflation.
I think it means that reduces the (present) value of the deprecation tax shelter. CFAT = (S-C)*(1-T) + T*D present value of the depreciation tax shelter = sum(T*D/(1+r)^t); The inflation causes “r” to increase, so the value of depr tax shelter decrease.
Very simple explanation: when inflation is very high, your asset is worthless (they “vanish” on the book). And if you have a very small book value to base your depreciation on, the result is very small depreciation. Since tax shield from depreciation is T x D, the tax shield would get “eaten” by the eroded depreciation. Now compound that with increased taxes (since it’s taxed on nominal income), you have one big problem on the book!