Schweser states that corporate income and capital gains tax rate are not indexed to inflation, inflation can reduce the investors return, unless this effect was priced into the stock when the investor bought it. I somehow have a hard time understanding this concept. Can someone perhaps explain better and/or with an example? Thanks,
Unexpected increase in inflation can affect corporate income negatively. Unless you are a perfectly monopoly firm (you can pass on all the input cost inflation onto your customer). For example, initially you expect inflation to be only 2%, so you use all your skill to calculate the required rate of return for this security, after all said and done, you decide this stock is attractive base on your 2% inflation assumption. So you buy the stock. During your holding period, inflation goes up to 4% unexpectedly; you get back to drawing board, and do all the math, then you are like, “oh Sh*t, this stock (based on 4% inflation assumption)is a piece of crap now, I need to sell it” Make sense?
Think of it another was (WS did a good job explaining it but perhaps not simple enough). A company is expecting 2% inflation and therefore expects to make $1 in the year in free cash. You like this $1 in free cash so you purchase the stock. However, unexpected, inflation is actually 30% and because the company has a lot of competition it cannot pass on any of the unexpected inflation. Therefore free cash is only $0.70. Your return as a stockholder got reduced a lot. Say the company (as WS pointed out) isn’t in a perfect monopoly and isn’t able to fully pass on 100% of the unexpected inflation. If this is true, free cash will be reduced accordingly.
I totaally understand this. But how is the corporate income and capital gains tax rate related?
We already covered off corporate income (see above). capital gains tax isn’t indexed to inflation so if inflation reduces corporate returns (aka free cash) you may decide to sell your stock sooner causing realization of capital gains. i’m reaching here. I wouldn’t worry about hte capital gains vs. inflation bit of this question.
Income is not indexed to inflation!! Otherwise, we will never have to be concerned about the inflation effect (how nice will that be!!). I guess I should say revenue is not indexed to inflation. NI=Rev-cost (I know I left many items in between) When you do your math, your initial net income projection is based on your initially revenue projection and your initially cost project, and you have to factor in inflation for the next period. So, if inflation changes unexpected (say going up), your cost figure will MOST LIKELY grow faster than your revenue figure…this leads to lower net income. I wouldn’t worry too much about tax…I personally don’t think tax rate has anything to do with inflation. Did this answer your question…maybe I didn’t understand what you were asking very well.
Capital gain tax is somewhat related. Imagine I buy s stock for $10. It does not pay any dividends. 3 years later price is $30. If I sell I will pay capitals gains tax for $20. However, if the compounded inflation rate was 30% for these three years, $20 dollar will not be capital appreciation. But the government will apply the tax rate to this amount. So if I didnot factor in the inflation to my required rate of return from the start, I would be losing.
This is similar to the TIPS argument. Principal and payments for TIPS are indexed to inflation, so you are protected, but the income is still taxed, and when it matures (or you sell it), any principal gain is taxed as a capital gain, even though its designed to be nothing more than an inflation adjustment. Thus, you are only protected from inflation by (1-taxRate)%. However, if you are a tax-exempt investor (like a pension fund, or endowment) TIPS actually does give you full inflation protection and a true risk-free rate (well, not quite, since the government could cook the books on how much inflation there is, but it’s as close as you can get to true risk free-ness).
ws Wrote: ------------------------------------------------------- > Income is not indexed to inflation!! Otherwise, > we will never have to be concerned about the > inflation effect (how nice will that be!!). I > guess I should say revenue is not indexed to > inflation. NI=Rev-cost (I know I left many items > in between) Remember from LII (the impact on P/E), the ability of the company to pass on the inflation to the consumer in form of higher prices. If possible, companies would like to do that, which would make revenue a nominal number.