Adequacy of Depreciation Allowances under Inflation

Teemu Aho and Ilkka Virtanen

Summary

This paper has examined the concept of inflation tolerance by using present values of the depreciation amounts in analysing all equity- financed capital projects. The investment under consideration must be regarded as marginal, since the internal rate of return was assumed to equal the rate of discount.

It has been emphasized in discussions concerning the adequacy of tax deductible depreciation allowances that only profitable firms find it feasible to protect against the harmful effects of inflation. This study has demonstrated that the relation between the lenght of life of the investment and the EVL approved rate of depreciation (j) is of crucial significance in determining the conditions for positive inflation tolerance. In the case j<2/(n + 1) positive inflation tolerance is impossible, whatever the profitability of the investment under consideration. Instead, increasing profitability merely accentuates the negativity of the inflation tolerance, s. This arises from the fundamental characteristics of realization depreciation. It is very sensitive to changes in both the lenght of economic life and rate of discount because of the double discounting procedure employed in its calculation. However, realization is the commonly acknowledged principle to be observed in determining corporate income and as the basis for corporate taxation.

The necessary, but not sufficient, condition for positive inflation tolerance was found to be j>2/(n + 1). In order to satisfy this condition, it is profitable for the firm to invest in assets with long estimated economic lives provided that the EVL determined rate of depreciation applicable to these is higher than the internal rate of return on the relevant asset. Once the condition j>2/(n + 1) is satisfied, increasing profitability raises inflation tolerance until the latter achieves its maximum value at the level of the internal rate of return i*. After this point, higher profitability is associated with decreasing inflation tolernce.

Inflation tolerance of depreciation is the higher, the longer the economic life of the asset in question. Inflation tolerance was also shown to increase with the rate of depreciation.

The adequacy of EVL depreciation allowances was examined in the light of the averange rate of inflation in Finland during the 1970īs (10.9 %). It was shown that the present allowances do not enable protecting the investment against a rate of inflation of this magnitude. For example, an investment with a lenght of life of ten years and an internal rate of return of ten per cent should have required a rate of depreciation of 43 % in order tolerate inflation of 10.9 % p.a, while the actual EVL allowance equalled 30 %. The EVL accepted rates of depreciation applicable to buildings were shown to be equally inadequate. They vary from five to ten percent, whereas at least a 20 % depreciation based on the declining balance method would have been necessary for producing protection against the average rate of inflation during the 1970īs.

The determination of inflation tolerance in this paper does not take into account the option of using debt capital as a form of finance. It debt capital can be utilized, the inflation tolerance of depreciation increases. The strenght of this effect is being analysed in the ongoing research based on the present paper.

Inflation tolerance has here been analysed with respect to separate investment projects. The tolerance of inflation for the whole firm may be defined as consisting of the sum of all these separate tolerance values, which implies that the growth of the firm is one of the factors to be taken into account in determining the firm-specific inflation tolerance. This remains to be accomplished in future research.

(The Finnish Journal of Business Economics 4-1981, 351-379)