Chapter 6. Tax and inflation impact (2016)
Resumen InglésUniversidad  Universidad de Barcelona (UB) 
Grado  Empresa internacional  3º curso 
Asignatura  Finances II 
Año del apunte  2016 
Páginas  12 
Fecha de subida  29/03/2016 
Descargas  12 
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CHAPTER 6: Tax and inflation impact in
investment analysis
NPV and IRR have to take into account the market variables that can change significantly their
results:
Taxes: the payment of a corporate tax is a negative cash flow for the company that
decreases the future financial results and as a consequence affects profitability of an
investment.
Inflation: affects the cash flows evaluation and may cause an investment profitability
to be overstimated
1. The NPV and IRR criteria taking into account taxes
The amount of the tax can notably reduce the profitability of an investment project.
Tj is the annual tax payment
How to calculate the tax payment
In order to determine the amount of the tax payment, we should take into consideration the
following:

The tax corresponding to year X is usually paid the following year, X+1. Anyway, this
can be simplified in the investment analysis and we can calculate it as paid in year X.
The tax payments not only influence the cash flows of the investments but also the
cost of capital (r).
Tax is calculated on the basis of accounting income, and not on the basis of cash flows.
*For tax purposes, the benefits are taxed in the period in which they are accrued or incurred,
and not in the period when they become liquid or received.
There are some tax deductible expenses that are not supposed to be cash flows for the
investment analysis. The most common is depreciation:
ACCOUNTING INCOME = REVENUES – EXPENSES
CASH FLOW = CASH RECEIPTS – PAYMENTS
Depreciation is a noncash expense, as the amortization is an expense but it’s not a payment,
then
CASH FLOW = ACCOUNTING INCOME + DEPRECIATION
Example 1:
Assume that you are buying 1.000 shares at the nominal value of 1.000 m.u. In year 1, you are
sure that you’ll get dividends of 100 m.u per share and in year 2, you can sell your shares at
1.200 m.u.
Other banking expenses are 2 m.u. per share annually:
a) Assuming that you would like to obtain a return of 4% (opportunity cost of capital) as
the minimum, would you be interested in this investment?
b) If you had to pay taxes of 35%, would you be interested in this project?
SOLUTION
Example 2:
A manufacturing company would like to renew their product line. There are 2 possible
alternatives:
a) Alternative A: requires equipment investment of 1.089 m.u.
b) Alternative B: requires equipment investment of 676 m.u.
The equity structure of the company is comprised of 60% of national capital, with the minimal
rate of return of 6%, and 40% of the foreign capital with the minimal rate of return of 11%.
The corresponding tax rate is 50% (assuming that interest rates/dividends of capital expenses
are not taxable).
The budgeted income statement for both alternatives is the following:
The duration of the investment project is 5 years.
For both investment alternatives we need a permanent initial financial layout in raw materials
and workinprocess of 105 m.u.
a) Which investment alternative is appropriate according to the NPV and IRR methods?
b) Comment on how consistent are these 2 methods in raking the projects
SOLUTION
Taking into account the permanent initial financial layout:
Determining accounting incomes and cash flows
Cost of capital
Can be estimated as a weighted average cost:
Determining NPV
Determinin “r”
2. The NPV and IRR criteria taking into account inflation
We should bear in mind that currency’s values change over time, and thus, its purchasing
power. So, net cash flows of different periods are not comparable if there are not capitalized
or actualized.
Differences between the chronological value and purchasing power of money
The chronological value of money means that C1 > Co.
The purchasing value of 1€ at the beginning of the period is GREATER than the
purchasing value of 1€ at the end of the same period, because after the prices have
risen, having the same amount of cash you can less things at the end of the period.
In practice, if there is inflation, the chronological value and purchasing power increase
and decrease in the same direction.
Interest rates are usually quoted in nominal rather than in real terms.
Over time, inflation will have an impact on cash flows
Taking inflation into account, we compensate the loss of purchasing power
In practice, the opp. cost of capital (r) includes some inflation premium. Real rate of
return = r’. Inflation rate = g.
C1 = Co x (1+g) x (1+r’) = Co (1+r)
For t periods:
Ct = Co x (1+g)t x (1+r’)t = Co (1+r)t
Inflation influence in NPV
Inflation tends to increase the apparent results of the investment projects. If we don’t take
into consideration inflation, we may overestimate the results.
Example 3:
We have the following data for the investment project A:
a) Determine NPV assuming that r=3%
b) How ould the NPV change if the inflation rate were 2% and real return rate were 3%?
What would be the nominal return in this case?
SOLUTION
Example 4:
For the following investment project:
a) Determine r
b) Assume that annual average rate of inflation equals 2%, determine the real r. Interpret
the results
Example 5:
Assume that you would like to make a financial investment of 3.000.000 m.u. with an intention
of recovering after 2 years 4.200.000 m.u.
a) It is recommended to undertake this investment project assuming a tax rate of 35%
and cost of capital r of 10%?
b) Is it recommended to undertake this investment project if the annual inflation rate is
3%?
Example 6:
The company XXX is considering to make an investment project with an initial
payment/investment of 1.000 m.u. that will generate an annual constant cash flow of 125 m.u.
a) Calculate the absolute and relative profitability of the project assuming that the
calculative interest rate is 5%.
b) What would be the NPV and IRR if the annual accumulative inflation rate were 6%?
3. Sensitivity analysis for investment decisions
There are some situations where we are unable to forecast what can happen. As a
consequence, when we prepare the cash flow forecasts it is necessary to determine the
situations that can happen with more probability and the possible consequences of these
events. This analysis is called sensitivity analysis, an analysis of how the changes in sales, costs
and other factors may affect the project’s profitability.
NPV and IRR are affected by changes in: initial investment, rate of return, cash flows.
Most important variables of the investment project are: market share, variable cost…)
Example 7:
This analysis helps determine the boundaries of profitability of investment and which variables
are more important.
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