Chapter 14: Taxes and Inflation

In this Excel tutorial, I'm going to be talking to you about inflation, income taxes and depreciation and how that can affect your rate of return. Before watching this tutorial you should go back and see the tutorials on depreciation, taxes and inflation to make sure you have the right background information to follow along with what's going on in this one. Now in this scenario, we have an inflation rate of 4.2%, we had a $15,000 investment, there's our benefits, salvage, income taxes and our years. The first thing we're going to look at is just what's our rate of return when we take into account nothing but our investment, our annual benefit and our years.

In this scenario it's simply equals, rate, our years is in B7, our payment is in B4 and our present value is negative B3. And you can see taking into account no inflation, no income taxes, no depreciation, our before tax rate of return is 20.78 percent. Now, let's take a look at what happens when we do after tax rate of return and ignore inflation. So I'm kind of taking this in steps. Notice just what the..the depreciation and taxable incomes going to do. In this scenario at year 0 we have a before tax cash flow of $15,000. It is not affected by taxes. We have our $4,000. We're not going to take into account inflation. We use straight-line depreciation, our taxable income, our income taxes, and then what is our after tax cash flow.

In this case, now let's solve for what our rate of return is. This is equals rate, we're gonna have the same year, but our payment is in H15 and our present value is in H14. Notice just by taking into account depreciation and taxable and taxes how much our rate of return has changed. Now let's go for the whole ball of wax. Let's go for after tax rate of return and let's put inflation into this. Now, impact of an inflation on before tax calculations is okay if your future benefits are keeping up with the inflation, but that's not always the case and then you started to get into depreciation and taxes and inflation and the whole ball of wax can really make a big difference.

So let's take a look at this one. I've set up my tax table very similar to the example on t..taxes that I requested you to watch. Taxes and inflation would be probably a good one. Okay, now in this scenario, we had $15,000 as our initial but notice at year 1 we had an inflation of 4.2%. So the calculation is equal B4, which is our $4,000 times 1 plus our inflation rate. And then each year notice that I've pulled down and made the inflation go for each year. So this took so this column from here to here took into account inflation. Now, we use straight-line depreciation, taxable income, income taxes, and then we got our after tax cash flow. Very similar to the previous tutorial. The only difference is we've got inflation mixed in here now. Now in order to convert to year 0 dollars and solve for rate of return I have to have a conversion factor.

It is simply 1 plus my inflation rate raised to the negative year, which is in C20. Notice here it's ne..raised to negative C21. So this gives us our conversion factor to get us back to year 0 dollars. So that's what you see here is getting us back to year zero dollars. Now, let's figure out what is our rate of return. We can simply here do IRR and highlight our values. And you can see our rate of return went down to 10.82%. Big differences. So what I really want you to notice is in this..in this tutorial is notice what are IRRs before taxes, notice what it is after taxes and then nes..notice what happens when you add inflation into the picture. It really can make a big difference and these are all factors as you really need to consider when evaluating a project.