Corporate Finance-Capital Budgeting

CFA Level II Corporate Finance
#1

Hi Anyone there,

I am going through Capital Budgeting. In effects of Inflation on Capital Budgeting Analysis i really dont understand when the book says that

  1. “Inflation reduces the value of depreciation tax savings.”

  2. “If inflation is higher than expected, the profitabilityof the investment is correspondingly lower than expected” does this mean that most of the upside that you have in profitability is due to inflation and there is hardly any real profit. So the higher the inflation lowe the profitability??

Some help on both the q’s. Thanks

#2
  1. depreciation expense is based on historical cost. In real terms, the depreciation tax shield going forward, in an inflationary environment, will be less.

Without more context on 2, I cannot be entirely sure. However, I believe your interpretation is wrong. I think that since capital budgeting involves discounting fixed cash flows, unexpectedly high inflation over the course of the project will reduce its value in real terms.

You Indians are lucky that I had a delicious Curry dish last night (feel like giving back a little).

#3

Howdy!

Babbabooey nailed this one: depreciation’s based on old (cheaper) dollars; in an inflationary environment it will be a smaller percentage of income and assets than in a noninflationary environment.

The rate that you use to discount nominal cash flows includes inflation. If inflation is higher than expected, you have, in essence, discounted the cash flows at too low a rate; if you discount at a higher rate the NPV will be smaller. You cannot conclude that _ most _ of the profitability stems from inflation; some of it does, but not necessarily _ most of it _.

My pleasure.

#4

Remember that we need to discount a series of cashflows that, in simple terms, look like

CFi = (Sales-Cost)*(1-t) + t*Dep = NOPAT + tax shield

If your initial valuation assumed 3% inflation, but now you want to consider 4%, your NOPAT will be approximately 1% higher. This assumes inflation effects Sales and Costs equally, which is not realistic (ie, CPI V. PPI), but this is the assumption. Of course, the tax shield remains fixed.

Now you need to revalue this cashflow at the higher discount rate. So if you used 11% initially, you should now discount at 12%. The NOPAT increase is mostly offset by the higher discount rate, but the fixed tax shield has a lower PV than what you found with the initial rate.

I had to walk through the whole process for this to sink in.