Chapter 16 DCF with Inflation and Taxation

1. 1.1 1.2 1.3 1.4 1.5 1.5 Objectives Explain the impact of inflation on interest rates and define and distinguish between real and nominal (money) interest rates. Explain the difference between the real terms and nominal terms approaches to investment appraisal. Explain the impact of tax on DCF appraisals. Calculate the tax cash flows associated with capital allowances and incorporate them into NPV calculations. Calculate the tax cash flows associated with taxable profits and incorporate them into NPV calculations. Explain the impact of working capital on an NPV calculation and incorporate working capital flows into NPV calculations.

D C F w i th In flatio n and T a x a tio n

In flatio n

In tere st R a te

T a xa tio n

I n c o r p o ra tin g W o rk in g C a p ital

S p e c i f ic In flatio n

G en eral In flatio n

R eal In tere st R a te

M o n ey In tere st R a te

C a p ital A llo w a n c es

F i s h e r 's E q u a tio n

2. 2.1

Inflation It is important to adapt investment appraisal methods to cope with the phenomenon of price movement. Future rates of inflation are unlikely to be precisely forecasted; nevertheless, we will assume in the analysis that follows that we can anticipate inflation with reasonable accuracy.
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2.2

Two types of inflation can be distinguished. (a) Specific inflation refers to the price changes of an individual good or service. (b) General inflation is the reduced purchasing power of money and is measured by an overall price index which follows the price changes of a basket of goods and services through time. Even if there was no general inflation, specific items and sectors might experience price rises.

2.3

Inflation creates two problems for project appraisal. (a) The estimation of future cash flows is made more troublesome. The project appraiser will have to estimate the degree to which future cash flows will be inflated. (b) The rate of return required by the firms security holders, such as shareholders, will rise if inflation rises. Thus, inflation has an impact on the discount rate used in investment evaluation. Real and money interest rate The money (nominal or market) interest rate incorporates inflation. When the
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(A) 2.4

nominal rate of interest is higher than the rate of inflation, there is a positive real rate. When the rate of inflation is higher than the nominal rate of interest, the real rate of interest will be negative. 2.5 Fishers (1930) Equation The generalized relationship between real rates of interest and nominal rate of interest is expressed as follow under Fishers equation: (1 + i) = (1 + r) (1 + h) Where h = inflation rate r = real interest rate i = nominal interest rate 2.6 EXAMPLE 1 $1,000 is invested in an account that pays 10% interest pa. Inflation is currently 7% pa. Find the real return on the investment. Solution: Real return = $1,000 1.1/1.07 = $1.028. A return of 2.8%. 2.7 EXERCISE 1 If the real rate of interest is 8% and the rate of inflation is 5%, what should the money rate of interest be? Solution:

(B) 2.8

Money cash flows and real cash flows We have now established two possible discount rates, the money discount rate and the real discount rate. There are two alternative ways of adjusting for the effect of future inflation on cash flows.
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(a)

(b)

The first is to estimate the likely specific inflation rates for each of the inflows and outflows of cash and calculate the actual monetary amount paid or received in the year that the flow occurs. This is the money (nominal) cash flow. The other possibility is to measure the cash flows in terms of real prices. That is, all future cash flows are expected in terms of, say, Time 0s prices. With real cash flows, future cash flows are expressed in terms of constant purchasing power.

2.9

EXAMPLE 2 Storm Co is evaluating Project X, which requires an initial investment of $50,000. Expected net cash flows are $20,000 pa for four years at todays prices. However these are expected to rise by 5.5% pa because of inflation. The firms cost of capital is 15%. Find the NPV by: (a) (b) discounting money cash flows discounting real cash flows.

Solution: (a) Discounting money cash flow at the money rate: The cash flows at todays prices are inflated by 5.5% for every year to take account of inflation and convert them into money flows. They are then discounted using the money cost of capital.

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Note: The question simply refers to the firms cost of capital. You can assume this is the money rate if you are given a real rate the examiner will always specify. Time 0 1 2 3 4 Money cash flow ($) (50,000) 21,100 22,261 23,485 24,776 Discount rate @15% 1 0.870 0.756 0.658 0.572 NPV = PV ($) (50,000) 18,357 16,829 15,453 14,172 14,811

(b) Calculate the real rate by removing the general inflation from the money cost of capital:
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(1 + r) = (1 + i) / (1 + h) = (1 + 15%) / (1 + 5.5%) = 1.09 r = 9% The real rate can now be applied to the real flows without any further adjustments. Time 0 14 Money cash flow ($) (50,000) 20,000 Discount rate @15% 1 3.240 NPV = Note: Differences due to rounding. 3. 3.1 Taxation and Investment Appraisal Taxation can have an important impact on project viability. If management are implementing decisions that are shareholder wealth enhancing, they will focus on the cash flows generated which are available for shareholders. Therefore, they will evaluate the after-tax cash flows of a project. Payments of tax, or reductions of tax payments, are cash flows and ought to be considered in DCF analysis. Assumptions which may be stated in questions are as follows. (a) Tax is payable in the year following the one in which the taxable profits are made. Thus, if a project increases taxable profits by $10,000 in year 2, there will be a tax payment, assuming tax at 30%, of $3,000 in year 3. (b) Net cash flows from a project should be considered as the taxable profits (not just the taxable revenues) arising from the project. Capital allowances (tax-allowable depreciation, or writing down allowances (WDAs) or depreciation allowances) Writing down allowance is used to reduce taxable profits, and the consequent reduction in a tax payment should be treated as a cash saving from the
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PV ($) (50,000) 64,800 14,800

3.2

(A)

3.3

acceptance of a project.

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