Capital investment incentives in an inflationary environment

Doenges, R. C.; Hamman, W. D. Article Capital investment incentives in an inflationary environment South African Journal of Business Management Provided in Cooperation with: University of Stellenbosch Business School (USB), Bellville, South Africa Suggested Citation: Doenges, R. C.; Hamman, W. D. (1983) : Capital investment incentives in an inflationary environment, South African Journal of Business Management, ISSN 2078-5976, African Online Scientific Information Systems (AOSIS), Cape Town, Vol. 14, Iss. 3, pp. 89-95, https://doi.org/10.4102/sajbm.v14i3.1150 This Version is available at: https://hdl.handle.net/10419/217832 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Capital investment incentives in an inflationary environment The South African example R.C. Doenges and W.0. Hamman Graduate School of Business, University of Stellenbosch The attention in this paper has been directed at the problem whether the 30% machinery investment allowance was sufficiently high enough seen against the background of the present double digit inflation. The authors arrived at the interesting conclusion that the shortfall at replacement is caused by the fact that depreciation for fiscal purposes is based upon historical cost and not on replacement cost. The investment allowance filled this gap and it was concluded that this allowance was high enough in the majority of cases. S. Afr. Bus. Mgmt. 1983, 14: 89-95 In hierdie referaat is gepoog om te bepaal of die 30% masjinerie beleggingstoelae hoog genoeg is gesien teen die agtergrond van die huidige dubbelsyferinflasie. Daar word tot 'n interessante slotsom gekom, naamlik dat die tekort wat by ver• vanglng ontstaan, veroorsaak word deur die feit dat depresiasie op historiese kosprys en nie op vervangingswaarde gebaseer word nie. Die beleggingstoelae vul dus hierdie gaping aan en daar word bevind dat die 30% beleggingstoelaag in die meeste gevalle voldoende is. S.-Afr. Tydskr. Bedryfsl. 1983, 14: 89-95 This paper was presented at the Annual meeting of the Financial Management Association in San Francisco, October 14, 1982 Prof. R.C. Doenges, Professor in Finance, University of Texas at Austin and visiting professor, Graduate School of Business, Stellenbosch Prof. W.D. Hamman,• Professor in Finance, Graduate School of Business, University of Stellenbosch, P.O. Box 610, Bellville 7S30 Republic of South Africa •ro whom correspondence should be addressed Accepted June 1983 The impact of increases in price levels, commonly referred to as inflation, on the capital investment decisions of firms has attracted attention for over a decade. The nature of this impact1•2 has been examined; methods for making capital budgeting decisions under inflation have been developed;3·4·5 the effectiveness of federal tax policies in offsetting the impact has been analysed 6• 7 and policy proposals designed to offset the impact of inflation on investment decisions have been made. 8 Over the same time period the Republic of South Africa has experienced both a high rate of inflation and a relatively high real growth rate. The South African Consumer Price Index has shown double digit inflation rates since 1973; 9 the compound rate for the decade 1971 - 1980 is approximately 13 0/o with recent ( 1982) estimates of a current 160/o rate. Over the same 1971-80 period, however, Gross Domestic Product has averaged a real growth rate of 3,6tr/t per annum. In such a situation it would be expected that high rates of inflation would have a depressing effect on investment in plant and equipment and would encourage the substitution of labour for capital. This has not been the case in South Africa. The value of capital stock in manufacturing industries has risen from RS 223 million in 1970 to R9 520 million in 1979, measured in 1975 rand, an annual rate of growth of 6,90/o (a higher rate of real growth than the economy as a whole). Over the same period, capital stock per employee in manufacturing has increased (in constant rand) at a 4,20/o annual rate. These facts indicate that a relatively high rate of investment -both absolutely and per employee - has been maintained in manufacturing industries in South Africa. Although a number of factors contribute to South Africa's economic -and investment -climate (natural resources, especially gold and international politi~l attitudes, along with more common general economic factors), it seems likely that a part of th~ re:ason for t~e maintenance of a satisfactory rate of capital mvestment in spite of high inflation is government policy. ~ince 1973 ~he South African Ministry of Finance has consciously prov!ded tax allowances intended to off set some of the negative e ffects of inflation on business investment in capital goods, , • 10 as well as to provide an investment mcent1ve. Two incentives, used in combination, have ~ incorporated into South African corporate tax 1 regula.t1ons f ~r manufacturing firms. 11 The first, termed a Machinery I~- tial Allowance' is essentially a form of accelerated depreaa- 90 tion. A firm can take the 'Initial Allowance' -currently equal to 250fo of the cost of the asset -as added deprecia· tion in the first year, with ordinary depreciation reduced proportionately. Thus if: I = Investment a = Initial allowance (Ofo) d = Depreciation (Ofo) m = Expect life in years then first year depreciation allowed would be equal to: a x I + (1a)l/m, instead of 1/m; in subsequent years, allowed depreciation becomes (1a)l/m. The second incentive, termed the 'Machinery Investment Allowance' provides a deduction, in the tax year of the pur· chase, of a percentage (currently 300fo) of the cost of the asset acquired. At the present time, the 300/o Investment Allowance with corporate taxes at 46,20/o is comparable to a (0,3)(0,462) = 13,860/o tax credit. In total then, the first year's deduction for a new investment with, say, a five year life, would be 0,31 + 0,251 + (0,75/5)1 = 0,71, or 700fo of cost, instead of normal depreciation of 200fo of cost. In recent years, however, the adequacy of these allowances has been questioned severely. MacGregor, for instance, has argued that with 100/o inflation the Machinery Investment Allowance should exceed 480/o (instead of 300/o) for five-year life assets; and 1000/o for ten.year life assets. In this article we will develop a methodology for estimating the required allowance and evaluate the adequacy of the present 300fo Machinery Investment Allowance. Although the intent of ihe tax allowances, when initiated, was both to encourage growth and to compensate for inflation, the present question is whether or not they are adequate as an offset to inflation. Thus we develop a methodo. logy that focusses on the adequacy of the Machinery Investment Allowance as an offset to inflation. A major concern of a firm's management in an inflationary environment is the extent to which current sources of funds fail to be sufficient to replace operating assets that are ending their useful lives. This deficiency is the determinant of the adequacy of tax allowances to offset inflation. To determine this deficiency we begin by considering the most general case: a stable (non growing) all equity firm with multiple assets, with an equal portion (in real terms) of the assets being replaced annually. In Exhibit I such a firm is described in the absence of inflation (but with the initial allowance included for depreciation purposes). If, as shown, dividends paid equal net profit, then in each year the firm retains exactly the cash flow required to replace retired assets. In Exhibit II we show the same firm with inflation, assuming that the impact of inflation is the same for both the cost of new assets and for Earnings before Oeprecia· tion and Taxes. If once again we assume that reported pro. fits are paid out as dividends, the cash available for asset replacement is clearly insufficient, because of inadequate depreciation allowances. Finally, in Exhibit III, we establish a normative benchmark to compare with the actual effects of inflation. Co. lumn 1 repeats the no.inflation case of Exhibit I, In column 2, the 'expected' amounts for each row are found by rais. ing the figures in column 1 by the compounded rate of in· flation. Thus we can see, for instance, that a stockholder S.-Afr. Tydskr. Bedryfsl. 1983, 14(l) who received a dividend of R26,90 in the absence of infla. tion should expect to receive R47 ,41, (the equivalent in real terms of R26,90) after five years of 120/o inflation. Similarly if depreciation were to increase with the inflation rate th~ no deficiency in cash flow for replacement would occur. In column 3 we repeat the actual results of five years of 120/o inflation (from Exhibit II) and in column 4 we find the difference between 'actual' and 'expected'. This shows that the deficiency in available cash flow has been reported as gross profit and thus paid out as taxes (the 'inflation tax bonus') and as 'excess' or 'bonus' dividends. On this basis a more formal model can be developed to identify an adequate tax allowance to offset the effects of inflation. Once again we assume that assets are replaced in equal real amounts annually and that all the variables determining earnings before depreciation and taxes are affected by the same rate of inflation as are the costs of replacement ~sets. If I = annual investment amount, X = earnings before depreciation and taxes, 0 = depreciation, T = taxes, P = profits ( = dividends), C = 0 + P = total cash flow after tax, A = required machinery investment allowance (in current rand), M = required machinery investment allowance (as a 0/o of investment), i = inflation rate, t = tax rate, m = asset life ( = number of assets), n = time period, with n = m, a = initial allowance, as a decimal, d = annual depreciation (1 - a) m, and r = rate of return on asset ( = RoA), then for any year, in the absence of inflation, X = m(r.l); 0 = al + (1-a)I = al + m.d.I; T = t(X-0); P = X -0 - t(X0); = (1-t)(m.r.I -O); A = X -T - P -I = 0. With continuous inflation in year 'm' the required investment to be made, Im, will equal the initial amount of investment being replaced (lo) adjusted for inflation by lc,(l + i). At the same time, ~ = r.m.Im = r.m.Ic,(l + i)m; but Om = a(m-l + dim-I + dJm_ 2 ••• dJo, Since m om = alm(l + i)- 1 + dlmI:(l + i)-n, As a result, total cash flow after tax (0 + P) will be C = Om + (1-t)CXm - Om) = x.(1-t) + tDm m = r.m.lm(l-t) + t[alm(I +i)- 1 + dlmE(] +i)- 0] (1) s. Afr. J. Bus. Mgmt. 1983, 14(3) At the same time, expected profit ( = dividends) will be real profit adjusted for inflation, or P.(l+i)m = (1-t)(m.r.Io -00 )(1 +i)m. Since Io= D0 = lm(l +i)-m, Po(l +i)m = (1-t)[rm Im(l +i)-m - lm(l +i)-j(l +i)m = (I -t)[rmlm - I.J = rmlm(l -t) - lm(l -t). (2) Then, if stockholders receive their expected real inflation adjusted dividend (without an 'inflation bonus'), net cash flow available for asset replacement will be m timd E(l+i)-n - rmlm(l-t) + lm(l-t) m = lm[ta(l +i)- 1 + td E (1 +i)-D + (1-t)]. (3) The deficiency in cash flow required for the new asset will then be: A = 1.- [Cm -Po(l +i)m] = Im [I - (1-t) -ta(l +i)- 1 -td E (1 +i)-'1 = tlm [I - a(l+i)- 1 -d f (l+ir'1, (4) but A is the cash deficiency at the time the investment is made. An adequate machinery investment allowance will be (a) Expressed as a percentage of investment; (b) Received in the year after the investment is made, and thus also subject to inflation; (c) Sufficient, as a deduction before taxes to equal 'A' on an after tax basis. Therefore M1 = Afl +i) ---r.r = (I +i) [I -a(l +i)- 1 -d f: (1 +i)-'1. (.S) I~ Tab~e 1, the required investment allowance (M) for assets With different rates of inflation is calculated. Tabla 1 Machinery investment allowance required for selected asset lives and inf latlon rates Asset life Inflation rate (years) 81/o 12'lo 16'lt 20'1t s 18,32 26,44 34,03 41,17 10 28,65 29,S4 48,9S S7,27 IS 36,78 48,86 58,66 66,9S 20 43,24 SS,63 6S,21 73,09 91 More important, it is clear that, if government provides a benefit equal to 'A'• it is doing no more than returning to the firm the amount of taxes that represent the,. fl tion bonus' (cf. Exhibit III). Actual taxes with inflati~: :; equal to: t(X-D) = t(r.m.I.) -tim[a(l+i)-1 + d E(l+i)-n). . At the same time expected taxes (real tax on real income mcreased by inflation) are: ' t(r .m.Io -lo)(l + i)m = trmI0 (1 + i)m -tI0 (1 + i)m The difference between actual and expected taxes (the 'inflation bonus') then is m t(rml.) - tlm[a(l + i)-1 -d E(l + i)-1 - [trmim -tIJ m = tim (1-a (1 +i)- 1 -d E (I +i)-n] (6) or the same as expression (4) above. The preceding eq. (.S) for 'M,' presents an adequate investment allowance for firms or industries which are free to raise prices in an inflationary environment. In South Africa, however, a number of predetermined industries are subject to price control. In general controlled prices will be set so that EBIT /Total Assets remains a predetermined percentage. In such cases, an allowance of 'M 1' will be inadequate since the denominators of the equation will lag inflation. To evaluate such a situation, we must ignore changes in profits and dividends, and, abstracting from our prior analysis and using the original assets being replaced as a base, we can say: (a) Cost of new assets = Io(l + i)m; I m (b) Normal (straight line) depreciation = ~ E (1 + i)°; (c) Cash flow effect of initial allowance (a) =lc,t [1 -;: f (l+i)° + a(l+ir-l - ~ f (l+i)D] m = lot [a(l +i)m-l -! E (l +i)°J; (d) Adjustment to convert cash flow required to a tax allowance received later -(I +i) - 10t(l + i)m Then, focussing on the cash flows that occur without regard to profit, we can identify the allowance required by M2 = (Adjustment) [Cost -Normal depreciation - Initial allowance] = (d) [a -b - c], or (I +i~ 1Io(l +i)m - .!Q.ml f (1 +i)° - lot [ao +ir-• tlo(l +t)m - ! f (I +i)° l! . 92 M _ 1 l(l+·)m+I _ (l+i) f (l+i)n _ 2 -t(l + i)m 1 m t [ a(l + i)m - a(~ i) f (1 + i)n J I = (1 + i) - (1 + i)(l + i) -m f ( 1 + i)n -a t mt + a(l +i)(l +irm f (1 +i)n m (7) = (1 + i) [ + + a(l + i)-1 - ( + -a) f (1 ~)-n J . (8) When M2 is compared to Mi, it can be seen -as expected -that the necessary investment allowance for a firm under price control is higher, since M2 - M1 = [ (1 +i) J__-a(l +i)- 1 -(J__-a) f (1 +i-"J t t m - (1 +i) [ 1-a(l +i)- 1 - (l ;a) f (1 +i)-n J m = (1 + i) [ +- 1 - (+-a) E o; i)-" m + (1-a) E (1 +i)-"J , m m = (1 + i) [ ( + - 1) ( 1 - E o; i)-" ) J (9) Since lit > 1, for O < t < l; and since f (1 +it" < l m for O < i < 1, M2-M1, is positive so long as i and tare positive but less than 1. One additional alternative is possible. In some cases a price controlled firm is permitted to include so-called 'additio_nal depreciation' in establishing its prices, so that the r~~ired percentage is based on (EBIT -Additional Deprec1at1on)/Total Assets. In theory, such additional depreciation is determined annually as the difference between the expected cost of the replacement asset and the normal (straight line) depreciation of existing assets; or, after taxes (1 -t) [ Io (1 + i)m - ~ E (1 + i)n] , If we convert this to a tax allowance received a year later, we have DA = (~I~il~ i)J) [ Io(l + i)m - ~ f (1 + i)n] = <\7/~~)mt) [ o +i)m -! to +i)n l = (1 + i)(l -t) [ + S.-Afr. Tydskr. Bedryfsl. 198 3, l4( 3) m {l + i)-m E (1 +i}n] tm (10) In order to determine the required investment allowance (M3) for a price controlled firm permitted to use 'additional depreciation' in price-setting we can set However, we can also express DA (eq. (10)] as: m DA = (1 + i) [ J__t -E (1 + i) -n - 1 + t (1 + ir n J tm tm m = (1 +i) [ <+ - 1) (1 -E o;i)-"> J , (ll) which is the same as eq. (9), or M2 - Mp Thus it is clear that M3 = M2 - (M2-M1) M3 = M1, As a result only two expressions - M1 and M2 - are required to determine the adequacy of the South African Machinery Investment Allowance: M2 for firms under strict price control and M1 ( = M3) for those not price controlled and for those price controlled firms permitted to use 'additional depreciation'. From a practical standpoint, at least one additional variable should be considered. Most South African firms use gearing (financial leverage) to some extent, with the result that the effects of inflation are thereby diminished. From the standpoint of our existing models (for M1 and Mi) the effect of gearing can most easily be introduced by estimating its impact on cash flows and converting the cash flow effect into the same terms as the required investment allowance. Thus if we assume that a constant portion of each asset required is financed by debt, the gearing ratio (g) is g -Debt - -in and the amount financed by equity will be In (1 - g). If we assume that equal annual loan reduction payments are made, they will be equal to gln/m for each asset; with inflation this will become gim f (1 + i) -n m for all assets. At the same time with inflation the new amount borrowed to purchase Im will be glm. Thus the net cash flow to the firm will be glm - g!m f (1 + i) - n, When this cash flow is converted to the terms in which M is expressed (by changing from a cash flow to a tax allowance) we have s. Afr. J. Bus. Mgmt. 1983, 14(3) m _ g(l+i) [lE (l+i)-"] - t m · (12) Using eq. (12) both M1 and M2 can be adjusted to take into account the effects of gearing: = (1 + i) [ I - a( I + i) -I - d f (1 + i) -n (13) m [ 1 1 _ a) E (1 + i) -n M2= (l+i) T - a(l+i)- 1 - (T -m - = <4E [ 1 - g -at(l + i) -i - (1 -g - at) f o;i)-n]. (14) The impact of gearing is clearly to reduce the required amount of the Machinery Investment Allowance. As Table 2 shows, for firms that are not price controlled or are allowed to use 'additional depreciation' in setting controlled prices, the present 300Jo rate is more than ample for a gearing ratio of 300Jo. However, firms under strict price control will find the allowance inadequate - even with 500/o gearing -if inflation exceeds 120Jo. (Table 3). Table 2 Machinery investment allowance required (%) for selected asset lives, inflation rates and levels of gearing (M 1) Asset life Gearing Inflation rate (years) (g) 80/o 120/o 160/o 200/o s 0 18,32 26,44 34,03 41,17 30 4,19 6,15 8,03 9,85 so neg neg neg neg 10 0 28,65 39,S4 48,95 57,27 30 5,58 7,90 10,03 12,01 so neg neg neg neg IS 0 36,78 48,86 58,66 66,95 30 6,67 9,15 11,34 13,31 so neg neg neg neg 20 0 43,24 55,63 6S,21 73,09 30 7,S3 10,06 12,21 14,14 so neg neg neg neg 93 Table 3 Machinery investment allowance required (%) for selected lives, inflation rates and levels of gearing (M 2) Asset life Gearing Inflation rate (years) (g) 8"10 12'1, 16'1, 20'1, 5 0 43,65 62,83 80,65 97,33 30 29,S3 42,54 S4,6S 66,01 so 20,11 29,01 37,32 45,14 IO 0 70,02 96,27 118,74 138,42 30 46,95 64,64 79,83 93,17 so 31,S7 43,SS 53,88 63,00 IS 0 90,78 120,06 143,53 163,13 30 60,67 80,36 96,21 109,SO so 40,59 53,89 64,66 73,74 20 0 107,26 137,34 160,25 178,80 30 11,S6 91,78 107,25 119,85 so 47,76 61,40 71,92 80,SS In conclusion, it appears that the South African tax policy may well have done what was intended: stimulate growth and offset inflation. If we consider the period of the late 1970s, when the inflation rate was about 130Jo per annum and the tax rate 420Jo, Column (1) of Table 4 indicates that a manufacturer (not strictly price-controlled) with relatively modest levels of debt should not have been harmed by the impact of inflation on investment. Specific firms - for instance, with uneven asset replacement patterns, or with cash flows unevenly impacted by inflation - may have had more (or sometimes less) of a problem. In general, however, it appears that tax policy was sufficient to offset inflation and even to encourage some investment, if the firm's capital structure included debt. Since gearing levels of 300Jo or more are common for South African firms, and, in manufacturing, asset lives typically average less than 10 years, such a result seems probable. For the same class of firms the future is more difficult. With an expected inflation rate of 160'/o and a current tax rate of 46,20Jo, Column (2) of Table 4 shows a higher breakeven gearing ratio than Column (1). However, since break-even gearing remains below 200Jo, the end result for many firms should be satisfactory. In contrast many price-controlled firms that are not allowed 'additional depreciation' (cf. Table 3) have undoubtedly felt some negative effects of inflation, whatever Table 4 'Break-even' gearing ratios for a machinery investment allowance of 30% and initial allowance of 25% (I). (2). Asset life (years) i = 13"1o, t = 420/o i = 16"1,, t = 46,2'1, s neg 4,64'1, 10 9,760/o 14,61 'lo IS 14,03"10 18,17'1, 20 16,17'1, 19,93'1, "See text. 94 their level of gearing. With expected inflation at 16% it seems unlikely that any such firms will escape some inflationary impact on their replacement investments. Serious as this situation may be, the overall result is not as bad as that represented by some widely-cited critics of the present allowances. In Table 5, where our results are compared with those of a critic's, it can be seen that tax policy is generally much closer to being adequate than he suggests, except for shorter-lived assets belonging to price controlled firms. Table 5 A comparison of M1 and M2 with critic's estimates of required allowances at 8% inflation and no gearing Asset life (years) M1 M2 Critic" 5 18,32 43,65 36,42 10 18,65 70,02 72,90 15 36,78 90,78 20 43,24 107,26 148,86 "Source: Ref. 10. From the standpoint of the government, maintaining - or even increasing -the allowances seems a reasonable policy. For the unlevered firm that is not strictly price controlled, an investment allowance of 300Jo or more does not equal the inflation tax bonus when inflation is at 160Jo. Since the inflation tax bonus for government is not reduced by the addition of gearing to the formula (gearing simply lowers the amount of non-borrowed funds required, and thus the investment base) a 300Jo (or higher) allowance should encourage growth by levered firms. The serious problem conAppendix S.-Afr. Tydskr. Bedryfsl. 1983, l4(J) fronting government is the plight of the strictly pricecontrolled firm. On balance, however, it appears that, for many firms South African tax policy has been a realistic and relative!; successful approach to the problem of offsetting the negative impact of inflation on investment and, in some cases, may also have served as a stimulus to investment. While higher current inflation rates may substantially reduce its usefulness as an investment stimulus, it should remain an adequate inflation allowance for firms able to maintain a gearing ratio of 200Jo or more, that are not strictly price-controlled. References 1. Kim, M.K. Inflationary effects in the capital investment process: An empirical examination. J. Fin. Sept. 1979, p.941. 2. Nelson, C. Inflation and capital budgeting , J. Fin, June 1976, p.923. 3. Bailey, A.O. (Jr.) & Jensen, D.L. General price level adjustments in the capital budgeting decision. Financ. Manage., Spring 1977, p.26. 4. Cooley, P.L. Roenfeldt, R.L. & It-Keong Chew. Capital budgeting procedures under inflation. Financ. Manage. Winter 1975, p.18. 5. van Horne, J. A note on biases in capital budgeting introduced by inflation. J. Financ. Quant. Anal. March 1971, p.653. 6. Landskroner, Y. & Levy, H. Inflation, depreciation, and optimal production. Eur. Econ. Rev. 1979, p.353. 7. Parker, J. & Zieha, E. Inflation, Income Taxes, and the Incentive for Capital Investment. Natl. Tax. J. June 1976, p.179. 8. Auerbach, A. & Jorgenson, D. Inflation-proof Depreciation of Assets. Harv. Bus. Rev. Sept.-Oct. 1980, p.113. 9. South Africa 1982; Official Yearbook of the Republic of South Africa, 8th ed. Johannesburg: Chris van Rensburg Publications, 1982, p.348, p.482, p.524. 10. MacGregor, I. Investment and other allowances - are they adequate incentives in an inflationary environment? Fact and opinion paper no. 7, Sept. 1978; Centre for Business Studies, Univ. of the Witwatersrand (R.S.A.) pp.2-3, 12-14. 11. Silke, A.S. (Ed.). /98/1 /982 Old Mutual Income Tax Guide, Old Mutual Insurance Co., South Africa, 1982, p. 86 fol. Exhibit I Multiple asset firm, no inflation Asset Total for firm Purchased at time 0 I 2 3 4 Year 5 Initial investment 100 100 100 100 100 500 Cash flow determinants Earnings before depreciation and tax (RoA = 30117o) 30 30 30 30 30 150 Depreciation 15 15 15 15 40 100 Gross profit (EBIT) 15 15 15 15 (10) 50 Tax (at 46,211/o) 6,93 6,93 6,93 6,93 (4,62) 23,10 Net profit ( = dividend) 8,07 8,07 8,07 8,07 (5,38) 26,90 Cash flow available 100 Cash required for new investment 100 Difference (deficiency) 0 ~--- Afr. J. Bus. Mgmt. 1983, 14(3) 95 Exhibit II Multiple asset firm, with 12% inflation Asset Total for firm Purchased at time 0 2 3 4 Year 5 Initial investment 100 112 125,44 140,49 157,35 635,28 Cash flow determinants EBDT (RoA = 30%) 30(1,12)5 33,60(1,12)4 37,63(1,12)3 42,15(1,12) 1 47,21(1,12) ~-n = 52,87 = 52,87 = 0,3In-l(l,12) = 52,87 = 52,87 = 52,87 264,35 Depreciation (SLD) 15 16,80 18,82 21,07 23,(i() 95,29 Depreciation (initial allowance) 39,34 39,34 --- Gross profit (EBln 37,87 36,07 34,05 31,80 (10,07) 129,72 Ta1l (46,20'/o) 17,50 16,66 15,73 14,69 (4,65) S9,93 Net profit ( = dividend) 20,37 19,41 18,32 17,11 (S,42) 69,79 Cash flow available (95,29 + 39,34) 134,63 Cash required for new investment (I 00)( I, 12)5 = 176,23 Difference (deficiency) (41,60) Exhibit Ill Multiple asset firm: actual vs expected with 12% inflation (It (2)" (3t (4)" Expected Actual Difference No Inflation Inflated (Ex I) [Ex IX(l,12)'] (Ex II) ((3)-(2)) EBDT ISO 264,35 264,35 0 Depreciation 100 176,23 134,63 (41,60) Gross Profit so 88,12 129,72 41,60 Tax (46,20'/o) 23,10 40,71 S9,93 19,22 Net profit 69,79 22,38 ( = dividend) 26,90 47,41 Cash flow available 100 176,23 134,63 (41,60) Cash req. for 176,23 0 inv. 100 176,23 Difference (deficiency) 0 0 (41,60) (41,60) "See Text