U

TOPIC 6

TAX AND INFLATION IMPACT IN

INVESTMENT ANALYSIS
TOPIC 6: CONTENT U
B

1. The NPV and IRR criteria taking into account taxes.

2. The NPV and IRR criteria taking into account inflation.

3. Sensitivity analysis
1- TAKING INTO ACCOUNT TAXES U
B
The NPV and IRR investment appraisal methods have to take into
consideration the impact of the market variables that can change
significantly their results.

TAXES INFLATION
Payment of a corporate tax is a Affects the cash flows evaluation
negative cash flow for the company and may cause an investment
that decreases the future financial profitability overestimation.
results and as a consequence affects
profitability of an investment.
dividends not deductible,
interest from loans yes
1- TAKING INTO ACCOUNT TAXES U
B
Corporate tax is a negative cash flow that needs to be taken into account.
The amount of this tax can be significant and notably reduce the
profitability of an investment project as follow,

C1 - T1 C2 - T2 Ct - Tt
NPV = C0 + + + .. …+
(1 + r) (1 + r)2 (1 + r)t

where Tj is the annual tax payment.

1- TAKING INTO ACCOUNT TAXES U
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When we determine a quantity of the tax payment that represent a
negative cash flow it is necessary to take into consideration the
following:

➢ The tax corresponding to the year t is used to be paid mostly in the

year t+1, although this requirement can be relaxed (simplified) in the
analysis of the investment projects.
in ESP. taxes from 2021, will be paid on July 2022. We will include this in the same year

➢ The tax payments not only influence the investment through the cash
flows but also the cost of capital r.
1- TAKING INTO ACCOUNT TAXES U
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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, and not in the period when they are made liquids.

• There are some tax deductible expenses that don’t suppose to be cash
flows for the investment analysis. The most common case is a
depreciation,
considered paid in cash
• Accounting Income = Revenues - Expenses
• Cash-Flow = Cash Receipts - Payments
Depreciation is a non-cash expense; as the amortization is an expense but it
is not a payment then, non-cash expenses

Cash-Flow = Accounting Income + Depreciation

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EXAMPLE

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.

• 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?

• If you had to pay taxes of 35%, would you be interested in this

project?
1- TAKING INTO ACCOUNT TAXES U
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SOLUTION 1/2:

Shares, N 1.000
Nominal Value 1.000 m.u. per share
Banking expenses 2 m.u. per share
Dividends 100 m.u. per share
Opportunity capital cost 4%

Year o Year 1 Year 2

Investment -1.000.000
Cash received 100.0001.200.000
Cash payments -2.000 -2.000
Cash flows (Total) -1.000.000 98.000 1.198.000

IRR 14,46%

NPV ( r=4%) -1.000.000 94.231 1.107.618 201.849

NPV (R=14,46%) -1.000.000 85.617 914428 0,00

1- TAKING INTO ACCOUNT TAXES U
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SOLUTION 2/2:

Shares, N 1.000
Nominal Value 1.000 m.u. per share
Banking expenses 2 m.u. per share
Dividends 100 m.u. per share
Opportunity capital cost 4%
Taxe rate 35%

Year o Year 1 Year 2

Investment -1.000.000
Cash received 100.000 1.200.000
Cash payments -2.000 -2.000
Taxes -34.300 -69.300
Cash flows -1.000.000 63.700 1.128.700
98.000*0.35
IRR 9,47%

NPV ( r=4%) -1.000.000 61.250 1.043.546,6 104.797

NPV (IRR=9,47%) -1.000.000 58.187,9 941.812,15 0,00

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B
EXAMPLE 1/3:

A manufacturing company would like to renew their product line. There are
two 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 local 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 dividends are not
deductable).
1- TAKING INTO ACCOUNT TAXES U
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EXAMPLE 2/3:

The budgeted income statement for both alternatives is the following:

A B
Sales revenue…………… 1.032,00 920,00
Raw Materials………… (182,50) (182,50)
Direct Labor…………… (328,50) (328,50)
Indirect/General expenses (109,50) (109,50)
Depreciation….. ………. (218,00) (135,00)
Dividends local capital… (53,00) (35,00)
Dividends foreign capital.. (50,00) (28,00)
------------ -----------
90,50 101,50
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EXAMPLE 3/3:

The duration of the investment project is 5 years.

For both investment alternatives we need a permanent initial financial layout

in raw materials and work-in-process of 105 m.u.

Questions:

a) Which investment alternative is appropriate according to the NPV and

IRR methods?

b) Comment on how consistent are these two methods in ranking the

projects.
1- TAKING INTO ACCOUNT TAXES U
B
SOLUTION 1/8:

Taking into account permanent initial financial layout:

Type A Type B

Investments ……. 1.089 676

Stocks ………. 105 105
--------- ---------
Total initial investment 1.194 781
1- TAKING INTO ACCOUNT TAXES U
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SOLUTION 2/8:

Determining accounting incomes and cash flows

A. B
Sales ………………………. 1.032,0 920,0
Cost of Goods Sold………..…. - 620,5 - 620,5
(Raw Material, Direct Labor,
Indirect/General expenses) ---------- ----------
411,5 299,5
Depreciation ……………….. - 218,0 - 135,0
---------- ----------
Profit before taxes………… 193,5 164,5
Tax rate (50 %) …………….. - 96,7 - 82,2
---------- ----------
96,8 82,3
Cash flows…..…….……….… 314,8 217,3
96,8 + 218 82,3+135
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SOLUTION 3/8:

Cost of capital

Can be estimated as the weighted average cost:

(0,6 x 0,06) + (0,4 x 0,11)

--------------------------------- = 0,08 = 8 % annual
0,6 + 0,4
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SOLUTION 4/8:

Determining NPV

(1 + 0,08)5 - 1
Discount rate component = ----------------------  3,99
0,08 (1 + 0,08)5

NPV (A) = - 1.194 + 314,75 x 3,99 = 62 m.u.

NPV (B) = - 781 + 217,3 x 3,99 = 86 m.u.
constant
cashflows
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SOLUTION 5/8:

Determining “r”:

Alternative A
(1 + r)5 - 1
314,75 ---------------- - 1.194 = 0 r A = 10 %
5
r (1 + r)
Alternative B
(1 + r)5 - 1
217,3 ---------------- - 781 = 0 r B = 12 %
r (1 + r)5
1- TAKING INTO ACCOUNT TAXES U
B
SOLUTION 6/8:

Determining “r”:

For the opportunity cost of capital 8% …..

 According to NPV, B is preferable over A, because…

NPV (B) > NPV (A)

• According to r, B is also preferable over A, because…

r (B) > r (A) > 8 %
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SOLUTION 7/8:

If the opportunity cost of capital r were different from 8 % …..

It is possible that NPV and IRR won’t coincide in ranking of the

alternatives, because there is the Fisher rate (f) in the first quadrant:

(1 + f)5 - 1 (1 + f)5 - 1
314.75 ---------------- - 1194 = 217.3 ---------------- - 781
5 5
f (1 + f) f (1 + f)

f = 5, 97%
1- TAKING INTO ACCOUNT TAXES U
B
SOLUTION 8/8:

NPV(r)

If r would be less than 5,97 %,

380
A
applying NPV, the alternative A,
305 would be more attractive, but
applying “r”, the alternative B would
B be better. In this case NPV and “r”
Fisher rate would produce conflicting rankings
85,6
61,6
(solve at home the ranking scale).

4% 8% 12 % k

f = 5.97 % rB = 12 %

rA = 10 %
2- TAKING INTO ACCOUNT INFLATION U
B

IT IS A FALSE ASSUMPTION to consider that the currency has

the same (constant) purchasing power over time.

• It is based on a monetary stability climate that doesn’t exist

anymore.

• Net cash flows of different periods are not comparable between

themselves: the cash flows corresponding to the periods
characterized by lower price levels have greater purchasing
power and as a consequence a higher real value.
2- TAKING INTO ACCOUNT INFLATION U
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Differences between the chronological value and purchasing power of
money,
• The chronological value of money means that C1 is worth more than C0
because C1 > C0 measured in the same units that the purchasing power do.

• The purchasing value of 1 euro at the beginning of a period is greater than

the purchasing value of 1 euro at the end of the same period, because after
the prices have risen with the same amount of cash you can buy more things
at the beginning of the period than at the end.

• In reality (in practice) both values appear together. If there is inflation, the
chronological value and purchasing power increase and decrease in the same
direction.
In fact we have…
C1 = (C0 x (1 + g)) x (1 + r’)
because of because of
inflation capitalization
 2- TAKING INTO ACCOUNT INFLATION U
B

• Interest rates are usually quoted in nominal rather than in real terms.

• With the passing of time, inflation will have an impact on cash flows (i.e.
salaries, cost of materials adjusted for inflation).

• Taking inflation into account, we compensate for the loss of purchasing power.

• Inflation has to be treated the same in both the cost of capital rate r and cash
flow estimates.

• If horizon is not so long, and project is analyzed within an stable scenario,

previous assumption could be relaxed and not applying any adjustment to
cash-flows.
 2- TAKING INTO ACCOUNT INFLATION U
B
DISTINGUISHING BETWEEN NOMINAL RATE AND REAL RATE

Invest (current euros) C1 Result

-1,000 € 1,100 € 10% nominal rate of return

With an expected inflation rate of 6%:

Invest (current euros) Real C1 Result

-1,000 € 1,100/1.06 = 1,037.74 € 3.774% real rate of return

1 + nominal discount/interes rate

Real discount rate = -------------------------------------- - 1
1+ inflation rate
2- TAKING INTO ACCOUNT INFLATION U
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 In practice the opportunity cost of capital r includes some inflation
premium.

 Therefore, r embeds two types of discount rates such as the real rate
of return r’ and the inflation rate g and it’s called as an “apparent”
profitability, it is as follows:

C1 = C0 x (1 + g) x (1 + r’) = C0 (1 + r)

 For t periods we have:

Ct = C0 x (1 + g)t x (1 + r’)t = C0 (1 + r)t

2- TAKING INTO ACCOUNT INFLATION U
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Inflation influence on NPV:

C1 C2 Ct
NPV = C0 + --------- + ---------2+ .. + ----------
(1 + r) (1 + r) (1 + r)t

g = annual average inflation rate, r = nominal discount rate, r’= real discount rate

C1 C2 Ct
(1 + g) (1 + g)2 (1 + g)t
NPV = C0 + ----------- + -----------2+ ... + -----------t
(1 + r’) (1 + r’) (1 + r’)
2- TAKING INTO ACCOUNT INFLATION U
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Inflation influence on NPV:

 Inflation tends to increase the apparent results of the investment

projects.

 If we don’t take into consideration inflation factor we run the risk of

overestimating the results and accepting unrealistic investment.
2- TAKING INTO ACCOUNT INFLATION U
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EXAMPLE:

We have the the following data for the investment project A:

Project Cash Flows

C0 C1 C2
A -1.000 500 900

Questions:

• Determine NPV assuming that r = 3%.

• How would the NPV change if the inflation rate were 2% and real return rate were
3%? What would be the nominal return rate in this case?
2- TAKING INTO ACCOUNT INFLATION U
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SOLUTION:

Without considering the effect of inflation:

500 900
NPVA = - 1000 + --------- + --------- = 333,77 m.u.
2
(1,03) (1,03)

Taking into account inflation, the result is:

500 900
NPVA = - 1000 + ----------- + ------------ = 291,31 m.u.
with g
(1,03) (1,02) (1,03)2(1,02)2
2- TAKING INTO ACCOUNT INFLATION U
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Inflation influence on IRR (1/3):

IRR basic formulation...

C1 C2 Ct
0 = C0 + ----------- + ----------- + …+ -----------
(1 + r) (1 + r)2 (1 + r)t

Taking into account the inflation rate g ...

C1 C2 Ct
(1 + g) (1 + g)2 (1 + g)t
0 = C0 + ----------- + ----------- + .. + ------------
2
(1 + r’) (1 + r’) (1 + r’)t
2- TAKING INTO ACCOUNT INFLATION U
B
Inflation influence on IRR (2/3):

C1 C2 Ct
0 = C0 + ------------------ + -------------------- + .. + --------------------
2 2 t t
(1 + r’)(1 + g) (1 + r’) (1 + g) (1 + r’) (1 + g)

Following, (1 + r) = (1 + r’) (1 + g) ….

C1 C2 Ct
0 = C0 + ----------- + ----------- + .. + ------------
(1 + r) (1 + r)2 (1 + r)t

r = nominal rate that doesn’t take into account the inflation factor
2- TAKING INTO ACCOUNT INFLATION U
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Inflation influence on IRR (3/3):

r-g
r = r’ + g + r’ g r’ = ------------
1+g

g0  r  r’

In the presence of inflation… r  real r (r´)

The nominal r is greater than real r

and there is a danger to accept the projects,
which are not profitable.
2- TAKING INTO ACCOUNT INFLATION U
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Example

For the following investment project:

Project Cash flows

C0 C1 C2
A -1.000 500 900

Questions:

• Determine r.
• Assume that annual average rate of inflation equals 2%, determine
the real r. Interpret the results.
2- TAKING INTO ACCOUNT INFLATION U
B
Nominal IRR (without taking into account inflation):

500 900
rA 0 = - 1000 + --------- + --------- 2 r = 23,11%
(1 + r) (1 + r)

If we take inflation into account (g =2%):

r-g 0,2311- 0,02

r’ = ---------- = --------------- r’ = 20,69%
1+g 1 + 0,02
2- TAKING INTO ACCOUNT INFLATION U
B
EXAMPLE:

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.

Questions:

a. Is it 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%?
2- TAKING INTO ACCOUNT INFLATION U
B
Solution 1/3:

Without taking into account inflation:

4.200.000 – 1.200.000*0.35
r 0 = - 3.000.000 + 2
(1 + r)
r = 12,25%

Because 12,25% ˃ 10% we are interested in this project.

The corresponding NPV is:

4.200.000 – 1.200.000*0.35
NPV = - 3.000.000 + 2 = 123.967 u.m.
(1 + 0,10)
2- TAKING INTO ACCOUNT INFLATION U
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Solution 2/3:

Taking into account inflation:

4.200.000 – 1.200.000*0,35
r’ 0 = - 3000000 + 2 2
(1 + r’) (1 + 0,03)

r’ = 8,98%

Because 8,98% < 10% we are not interested in this project!

Another way to solve it:

r-g 0,1225- 0,03
r’= ----------- = ----------------- r’ = 8,98%
1+g 1 + 0,03
2- TAKING INTO ACCOUNT INFLATION U
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Solution 2/3:
Graphical presentation

NPV(r) g=0% NPV(r*) g = 3%

780.000

563.012

123.967

10 12,25 r 8,98 r*
2- TAKING INTO ACCOUNT INFLATION U
B
EXAMPLE:

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.

Questions:

A) Calculate the absolute and relative profitability of the project

assuming that the calculative interest rate is 5%.

B) What would be the net present value and internal rate of return if the
annual accumulative inflation rate were 6%?
2- TAKING INTO ACCOUNT INFLATION U
B
Solution (1/2):

A) Absolute profitability/ return

125
NPV = - 1.000 + NPV = 1.500 m.u.
0,05

Relative profitability/ return

125
r 0 = - 1.000 + r = 12,5%
r
2- TAKING INTO ACCOUNT INFLATION U
B
Solution (2/2):

B) Absolute profitability/ return

125
NPV = - 1.000 + NPV = 106,19 m.u.
0,05+0,06+(0,05*0,06)

Relative profitability/ return calculated as follow,

r = 12,5%
r-g 0,125-0,06
r’ = = r’ = 6,13%
1+g 1+0,06
2- TAKING INTO ACCOUNT INFLATION U
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EXAMPLE:

The credit risk committee of your bank has required you to calculate interest
rate to apply if you want to get a profitability of 5% net of inflation and you
estimate inflation rate in 3%,

r = r’ + g + r’ g

r = 0,05 + 0,03 + 0,05*0,03 = 0,0815

r =8,15%
3. SENSITIVITY ANALYSIS U
B

Uncertainty means that more things may happen than those that
actually will. Consequently, when examining cash flow forecasts, we
need to establish what else may happen and what the consequences of
these possible occurrences are. This is called a sensitivity analysis.

Sensitivity analysis: Analysis of the effects that may be caused by

changes in sales, costs and other items with regard to a project’s
profitability.
3. SENSITIVITY ANALYSIS U
B
It is impossible to know, with the utmost certainty, the net cash
flows that will be generated by an investment project in the future.
The quality of the Net Present Value (NPV) and the Internal Rate
of Return (IRR) will depend on how correctly net cash flows, and
even the actual discount rate, are calculated.
Sensitivity analysis consists of analysing the extent to which the
estimation of each one of the variables that affect the NPV or the
IRR may vary, without this meaning that the decision to accept the
investment project may prove not to be correct.

The limitation of the sensitivity analysis is that only the effect on

one variable can be analysed, while all the other variables remain
invariable.
3. SENSITIVITY ANALYSIS
U
B
EXAMPLE:

Q0: - 20 • The sensitivity analysis could be performed in

Q1: + 10 the following way:
Q2: + 6 • For example, for the NPV of this investment to
Q3: + 12
be positive...

k: 6%
✓ Q0 must be in the range (-24.84, 0)
NPV = 4.85 ✓ Q2 must be in the range (0.56, ∞)
IRR = 18.26%
✓ The interest rate “k” must be positive and
be below 18.26% (which is the calculated
IRR)

This results analysis facilitates the qualitative study of the

sensitivity and the importance of the different variables.
3. SENSITIVITY ANALYSIS U
B
EXAMPLE: Calculation of the sensitivity of Q2.
Q0: - 20 For the NPV of this investment to be positive...
Q1: + 10
Q2: + 6 10 Q2 12
Q3: + 12 0 = -20 + + +
(1.06) (1.06)2 (1.06)3
k: 6%
10 12
NPV = 4.85 Q2 = [+ 20 - - ] * (1.06)2
IRR = 18.26% ( 1.06) (1.06)3

Q2 = [+ 20 - 9.43 – 10.08] * (1.06)2 = 0.46 * (1.06)2 = 0.55

Therefore, Q2 must be in the range (0.56, ∞),

since if Q2 = 0,55 then NPV = 0

© FC -
FEE
3. SENSITIVITY ANALYSIS
U
B
% Level of Variation (LV): Maximum LV of a
variable with regard to the estimated value

MAX or MIN value that

the X variable may take
% LV (X) = 1
REAL or ESTIMATED
value of the X variable

The variables to which the investment project’s profitability is

more sensitive are those which may support a lower level of
variation for the NPV to continue to be positive or the IRR >k

© FC - FEE
3. SENSITIVITY ANALYSIS IN INVESTMENTS
U
B
Analysis of the Level of Variation of the
example:

-24.84 Q0 may increase by

% LV (Q ) 0 = 1 = 0.242 = 24.2% 24.2% at most
-20.00
0.56
Q2 may diminish
% LV (Q) 2 = 1= 0.9067 = 90.67 % by 90.67 % at
6 most

18.25% k may increase by

% LV (k) = 1 = 2.0417 = 204.17% 204.17% at most
6%

© FC - FEE
 U
B

TOPIC 6

Problems set
TOPIC 6 - PROBLEM 1 U
B

Company XXX faces 2 investment alternatives with the following

characteristics,

a) It is necessary to make an initial investment of 1.000 m.u.; it will generate

a perpetual annual cash flow of 120 m.u.

b) It is necessary to make an initial investment of 1.500 m.u.; it will generate

a perpetual annual cash flow of 150 m.u.

If the real cost of capital is equal to 5%, ¿ at which annual inflation rate one
alternative is preferable over the other according to the NPV method ?.
TOPIC 6 - PROBLEM 2 U
B
Suppose that someone asked you to make a feasibility study of an investment project
that lasts two years and requires an initial investment of 2,000 m.u. It is estimated
that the project would generate the cash flows of 1,800 m.u. in the first year and 600
m.u. in the second year.
The amortization of the project is linear and its residual value is 200 m.u.

Run the calculations for the following scenarios:

a) The company estimates a capital cost of 3% , there is no inflation and it is tax
exempt.
b) The company estimates a capital cost of 3%, it is projected a cumulative annual
inflation rate of 4% and it is tax exempt.
c) The company estimates a capital cost of 3% , there is no inflation and it is subject
to a tax rate of 35 %. You plan to sell the machine for 600 m.u.
d) The company estimates a capital cost of 3%, it is projected a cumulative annual
inflation rate of 4% and it is subject to a tax rate of 35%. You plan to sell the
machine for 600 m.u.
TOPIC 6 - PROBLEM 3 U
B
The company Alfa Inc. is going to buy a machine costing 8.000 m.u. with a useful
life of 4 years, at the end of which it won’t have residual value. Depreciation is
provided at constant quotas.
Thanks to this investment, according to the market study, the company will be able
to sell 5.000 products (pieces) the first year, 5.500 the second year and 6.000 the
third and fourth years, at a price of 1 m.u.
The production fixed costs were estimated at 500 m.u./year and variable costs at 0,30
m.u./piece.

Note: At the end of the fourth year the company is going to sell the machine for a
total of 1.000 m.u.
Questions

a) Calculate how profitable this investment project would be.

b) How would it affect the profitability if the company was subject to a tax rate of
30%?
c) Taking into account the previous point, please, calculate the real return assuming
an annual inflation rate of 2%.
TOPIC 6 - PROBLEM 4 U
B
In 2008, one of your best friends offered you an opportunity to buy a land assuring
you that in five years it’ll be possible to sell it for 300,000 m.u. During the next three
years it’ll be necessary to pay 6,000 m.u. annually in the concept of urbanization
costs.

Questions

a) What would be the maximum price you should pay for the land if you want to get
a return (profitability) of 6% ​a year?
b) Taking into account the result of the previous question: what would be the
maximum payment for urbanization if you want to get a return of 5%?
c) Taking into account the result for the land cost obtained in the paragraph a): what
would be the minimum amount you should sell the land for in order to get a
return of 8%?
d) Taking into account the result for the land cost obtained in the question a), as the
annual payments the result obtained in the question b) and as the selling price the
result of the point c): what would be the maximum profitability obtained ?
TOPIC 6 - PROBLEM 5 U
B

A financial institution offers your company to invest 20.000 m.u. at an annual

interest rate of 5% with the repayment of the initial payment in four equal
instalments.

Before making a final decision the finance director asks you to do the following
calculations,

a) What will be the amount of each annuity?

b) What is the profitability of the bank deposit?

c) In case of supporting a tax rate of 25% what the effective return (profitability)
will be?
d) In case of having an annual cumulative inflation rate of 4% what the relative
profitability will be?
TOPIC 6 – PROBLEM 6
U
B
An investment project requires an initial outlay of 1500 mu

The project’s duration is 4 years and the expected net cash flows are as
follows:
(In mu)

Q1 50
Q2 500
Q3 1,000
Q4 1,250
Exercise:

Calculate the sensitivity of Q0, Q3, k, based on the NPV, knowing that the
interest rate (opportunity cost) is 10%.
Which one of the three variables is most sensitive to the NPV ?.

© FC - FEE