I am having difficulty understanding this. Can anyone explain this “A company invests in depreciable assets, partly financed by issuing fixed rate bonds. If Inflation is lower than expected, the value of real tax savings and the value of real after tax interest expense are both increased” If inflation is lower means interest rates are lower. That means NPV of DXT (depreciation x tax) will be higher as the discount rate will be lower and so is the case of interest (higher NPV for future interest due to lower discounted rate). Is that how this works? Thanks.
key point here is “lower than expected”, so if a firm purchases a depreciating asset and finances it with a fixed rate bond, the value of the tax savings in real terms increases. Think, if i am paying interest expense of $1000 and my tax savings is $400 and when i issued the bond inflation was eating away at $100 of that savings and now inflation is lower (but my interest expense and tax rate don’t change) the impact of inflation on my savings is now $50. Hence the value of the real tax savings has increased.
Excellent. Thanks. Now I understand the after tax savings increased but how does the after tax interest expense increased. you are paying the same interest
Remember that if inflation is lower than expected the issuer (borrower) wins and investor (lender) losses. Vice versa.
where’s this from? Just looking for context. I think the idea is that real value of the $$$ amount is greater with lower inflation.
Capital Budgeting/Corporate Finance Page 75 Q9A. CFA EOC
june2009 Wrote: ------------------------------------------------------- > Remember that if inflation is lower than expected > the issuer (borrower) wins and investor (lender) > losses. Vice versa. Isn’t it the opposite? If inflation is HIGHER than expected, then my fixed-rate 5% mortgage (as a borrower) is a ridiculously good deal.
there is an erratum on this question, if I am not mistaken. please keep a printout of the errata sheet while you go thro’ this, definitely.
My bad…I think you’re right… I’m a company. i borrow dollars and agree to pay you back a set interest rate or dollar amount. if inflation jumps then I am paying you a rate or amount that can purcahse less goods. company wins, investor losses. If inflation rates fall (or are less than expected), then the dollars i pay you back are more valuable. Investor wins, company losses. I’m a lender or a bond investor. I give you dollars and expect to get or a rate back. if inflation jumps then the dollars i get back are less valuable and i LOSE. The company wins. If rates fall then the rate or i get back and more valuable, I win, company losses. So… If rate rise, investor (lender) looses If rates rise company (borrower) wins if rates fall, investor (lender) wins if rates fall, company (borrower) loses That seem right??
CPK i don’t see this specific question in the errata. If inflation is lower than expected, the value of the depreciation tax savings and real after-tax interest expense increases (lower discount rate). June, that’s basically right. If you owe someone money, you want high inflation so you can pay them back with cheaper $$$.
Yes CPK, I just checked Errata and could not find it. Thanks ro424. I got it