Effects of Inflation on Capital Budgeting Analysis

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.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop GMAT® Exam Prep


    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    2021-02-18
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    2021-02-13
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    2021-01-27
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    2021-01-14
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    2021-01-07
    Crisp and short ppt of Frm chapters and great explanation with examples.