Effects of Inflation on Capital Budgeting Analysis

Inflation affects the analyst’s decision on whether to run the analysis in nominal or in real terms where nominal cash flows include the effects of inflation and real cash flows are adjusted downward to remove the effects of inflation.

A nominal discount rate should be used to discount nominal cash flows and a real discount rate should be used to discount real cash flows. Below is the relationship between real and nominal rates.

$$ (1+\text{Nominal rate})=(1+\text{Real rate})(1+\text{Inflation rate}) $$

Ways in which inflation affects capital budgeting include:

1. Inflation shifts wealth from taxpayers to the government. Corporate taxes increase when there is higher-than-expected inflation because it reduces the depreciation tax shelter.
2. Inflation reduces the value of fixed payments to bondholders. When inflation is higher than bondholder’s expectation, the real payments are lower than expected, thus shifting wealth to the corporations that issued the bonds.
3. Depending on the prevailing inflation rate, a company’s after-tax cashflows will be better or worse of depending on how revenues and costs react to the changes in inflation. 

Question

Higher than expected inflation most likely:

1. Reduces the value of the depreciation tax shelter.
2. Increases the real payments to bond holders.
3. Increases the profitability of the investment.

Solution

The correct answer is A.

Inflation lowers the value of depreciation tax savings. A higher inflation than expected increases the firm’s real taxes as it reduces the value of the depreciation tax shelter. Thus, higher inflation shifts wealth from taxpayers to the government.

B is incorrect. When inflation is higher than bondholder’s expectation, the real payments are lower than expected, thus shifting wealth to the corporations that issued the bonds.

C is incorrect. The profitability of the investment decreases if the inflation is higher than expected.

Reading 19: Capital Budgeting

LOS 19 (b) Explain how inflation affects capital budgeting analysis.