In general, an inflationary economy distorts decisions about the capital budget. First, depreciation charges are based on the original costs rather than the replacement costs. As income grows with inflation, taxes are imposed in a larger proportion, with the result that real cash flows do not keep pace with inflation. Let’s look at an investment proposal that costs $ 24,000, assuming no inflation is expected, that depreciation is in a straight line for 4 years and that the tax rate is 40%. The following cash flows are expected to occur.
The depreciation is deducted from the cash savings to obtain the taxable tax, on which the 40% taxes are based. Without inflation, depreciation charges represent the “cost” of replacing the investment as it wears out. Since the nominal income on which taxes are paid represents real income, the last column represents real cash flows after taxes. The internal rate of return that equals the present value of cash income with the cost of the project is 14.96%. Let’s see now a situation in which inflation is at a rate of 7% per year and it is expected that savings in cash they grow at that global rate of inflation. After-tax cash flows become.
Although these cash flows are greater than before, they should be deflated by the inflation rate if one is concerned with the actual rate of return as opposed to the nominal rate. Therefore, the last column becomes:
As we can see, the real cash flows after taxes are lower than before and decrease over time. The reason is that the depreciation charges do not change according to inflation, so that a growing part of the savings in taxes is subject to liens. As taxes increase at a faster rate than inflation, real cash flows after taxes must decline. The internal rate of return based on real cash flows after taxes is 12.91%, compared to 14.96% without inflation.
Therefore, the presence of inflation results in real rates of lower yields and fewer incentives for organizations to make capital investments. The cash flow situation improves with an accelerated depreciation, but the same unfavorable comparisons follow. There is simply a disincentive for organizations to make capital expenditures, so they tend to invest less, seek investments with a faster recovery (shorter economic life) and become less capital intensive during periods of inflation. To learn more about such economics related topics, you need to visit BusinessStudyNotes http://www.businessstudynotes.com/. Business Study Notes is all about BBA, Mba, and B.com & M.com related studies and notes online. We may also say that the students of MBA, BBA, and B.com & M.com may easily get ready for their exams through business study notes.