Analysing Relationships between Straight Line Depreciations and Declining Balance Depreciations under Inflation

Teemu Aho and Ilkka Virtanen

Summary

This paper analyses the relationships between two different depreciation methods in inflationary conditions: straight line depreciation based on the replacement value (called JHH depreciation) and declining balance depreciation based on the original purchase price (EVL depreciation).

Inflation diminishes the real present value of EVL depreciation allowances, whereas JHH depreciation amounts are sized so that inflation has no effect on the real present value of their sum. The effect of inflation on the present value of EVL depreciation allowances is the less the more accelerated depreciation (the higher a rate of depreciation) can be utilized. The upper limit of acceleration is the writing off of the whole purchase price in the first period. If the rate of depreciation is denoted by j(0), the real discount rate by i and the rate of inflation by s, this lump-sum depreciation is still sufficient to provide a hedge against inflation (compared with stable price level situation), if s = s(1) = (1-j(0))i/(1+i)j(0). On lower rates of depreciation the critical rate of depreciation to hedge against inflation is j(s) = j(0) + ((1+i)j(0)/i)s.

Secondly, the paper analyses that case where the rate of depreciation j in the declining balance method is sized to equate the present value of EVL depreciation and that of JHH depreciation. We obtain the JHH-equivalent inflation- adjusted depreciation rate j = i(s)a(n,i)/(n-a(n,i)), where n is the lenght of the service life of the investment, i(s) = i + s + is is the nominal discount rate and a(n,i) is the present value factor for uniform series.

Next the financing of the investment is also taken into account in the analysis of the relations of the two depreciation methods. We assume that debt capital is inflation-protected (i.e. it can be paid back in nominal value). If the fraction of equity financing is denoted by e, the JHHR -equivalent inflation-adjusted EVL depreciation rate becomes j(e,s) = i(s)(e a(n,i) + (i-e)a(n,i(s))/(n-e a(n,i)-(1- e)a(n,i(s)) (JHHR depreciation = financing-adjusted JHH depreciation).

If the investment is financed using debt capital as the sole financing form (e = 0), we get j(0,s) = i(s)a(n,i(s))/(n-a(n,i(s)). This last equation is by appearance of the same form as the equation defining the JHH-equivalent inflation-adjusted j (100 % equity financing), only the real discount rate in the present worth factor being replaced by the nominal discount rate i(s) = i+s+is. When the primary form of finance is debt capital, the JHHR-equivalent rate of depreciation in declining balance method turns up markedly lower than the JHH-equivalent rate of depreciation, the latter being determined without adjustment for form of finance.

(The Finnish Journal of Business Economics, 3- 1983, 286-303)