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)