Corporate Finance 002: Taxes and Inflation

Effects of Taxes on Rates

If the cash flows from a certain investment is subjected to tax, then the rate of return need to be adjusted to reflect the effect of tax. This generally lowers our returns from investments.

On the flip side, the interest payment for certain types of loan are exempted from tax. This effectively reduces the interest rate of our loans in proportion to the tax rate.

It is important to keep the effects of taxes in mind for any forms of investments. For example as a Singaporean investing in U.S. company stocks, any dividends that I receive is subjected to a 30% tax. Therefore, I would have an additional consideration when making investment decisions as compared to a U.S. investor.


Effects of Inflation on Rates

Inflation does not directly impact our returns on investments, but it reduces the purchasing power of our money over time. Therefore, there is a distinction between real value and nominal value, where real value had taken into account inflation.

To calculate the real value of an investment, the cash flows have to be discounted with real interest rate. Relationship between real interest rate, nominal interest rate and inflation is captured by this formula:

real rate formula.JPG

RR is the Real Rate. Sum with 1 prevents division by zero error.

And as a rule of thumb, always find real value with real rate, and nominal value with nominal rate. Never mix them up when dealing with inflation.

In my opinion, it is important to understand and take note of the effects of inflation when investing for the long term, for example retirement funds. The medical costs and costs of living may have increased quite a bit due to inflation by the time you start drawing out your retirement funds, resulting in you not being able to meet your daily needs. It is therefore necessary to plan ahead carefully.

 

(Reference: Coursera Wharton Online Introduction to Corporate Finance)

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