Hey guys, could you help me with a question I have regarding corporate finance? On page 41 of the CFAI text, “Inflation reduces the value of depreciation tax savings.” While I certainly believe it to be true, I just can’t visualize it. Thanks.
inflation pretty much reduces the true value of any savings, no? what’d a car cost to buy in the 1950’s? if you had $5k then, maybe it bought you a car. today, if you had that same $5k, it doesn’t buy you a car. so if prices of things or services go up, the $$ you save (in general, sure- insert depreciation tax savings) is “worth” less/has less value than if prices had stayed the same and there wasn’t any inflation.
Yea, I understand. In my head, I was thinking more of a financial statement construct, like lower accounting income and I wasn’t thinking of the economic side of it. Thanks bannisja.
The way I reason through it is that higher depreciation leads to less paid in taxes and thus higher cash flows. I would think it plausible to assume that higher inflation leads to higher discount rate thus reducing the value of this component of the cash flow. If anyone has something to add or criticize please feel free.
I haven’t seen this in the readings yet and I wonder if it means relatively smaller tax shield. I’m thinking it relates to the fact that depreciation is a fixed charge. Say EBITDA in year 1 is $2000 and depreciation is $500. If, in year 10, everything holds except inflation causes EBITDA to be $5000 and depreciation is still $500 then you’re getting a (relatively) smaller tax shield (as a % of total taxes paid). Like I said, haven’t studied this yet. Feel free to hack that apart…
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Young_Prof, Thats what I originally thought, and maybe you can spin it as being a correct line of thought, but CFAI didn’t elaborate on it, and there were several other parts I found confusing in that same reading that CFAI did a good job of explaining, so I am lead to think it is meant to be something very obvious, i.e. present value, as opposed to be a sticking point or else they would have clarified it.
the way I see it in a perfect world without inflation - depreciation is deductible creating tax savings - that is a tax shield in a real world with inflation - depreciation does not reflect the real loss in value so basically we are not deducting as much depreciation as we should so the tax shield is reduced. Am I talking nonsense?
It’s a PV problem. The higher inflation, the lower the present value of depreciation tax savings (which is equal to depreciation*(1-tax rate)).
Here is how I understand it, You purchased a book for $100 a year ago expecting to depreciate all 100% in a year . A year later, inflation is at 50% and you depreciate the asset. You recognize $100 against taxes but this is offcourse a nominal value. The $100 today is worth only 50% of the $100 you paid for the book. So in the end you recognized total tax shield of $50. Hopefully it makes sense.
well depreciation is fixed, if inflation goes up and interest rate would go up too, then PV of Tax shield will decrease.
so simply explained…too nice… thanks a lot. i knew but was not able to grasp…
Nice and sound 
The original post was in 2008… 8 years later.
Time is money!! $$$
hahaha
Inflation hasn’t reduced the value of the answer.
This is a time value of money concept. Inflation is factored into the discount rate. Higher inflation, higher discount rate, lower TMV