I have some doubts on Effect of Inflation on Capital Budgeting Analysis: 1. How Inflation reduce the Depreciation Tax Saving? 2. How Inflation reduce the fixed payments to bondholders? plz explain these 2 points thanks
1). If you bought a new piece of equipment today - your price is going to be higher bcos of Inflation - and therefore depreciation expense will be higher. But your piece of equipment is at historical cost - so you are charging a depreciation based on the historical cost - so it is lower, so depreciation tax shield is also lower. 2) Fixed payments to Bondholders are based on the old historical cost signed up for when the loan was taken. If the same loan had been taken today- the loan amount would have been higher - bcos of inflation - and so fixed payments would also have been higher.
- I think the key here is that depreciation is based on historical cost. So, if you have rampant inflation, all your expenses are going up massively but depreciation stays the same. So the tax shield (the taxes you save by deducting depreciation) is less when prices are increasing because depreciation is stagnant while all your other expenses are going up.
Another take on this is that inflation actually erodes real purchasing power of money and in the case of fixed payments to bondholders, the bondholders are actually suffering from erosion of real purchasing power due to extremely high inflation. Whereas, the depreciation tax shield is based on historical cost estimates, (i.e. d*(1-t) ) the depreciation should have been higher if the asset were to be bought today at a higher price to show higher depreciation tax shield, whereas this is not the case… due to lower prices in the previous period when inflation was low.