Adjusting discount rates for income taxes and inflation: a three-step process.

Abstract

Income taxes and inflation must be correctly accounted for in forest valuation and investment analysis. In a specific analysis, the discount rate and all costs and revenues should be either before or after taxes, and they should include or exclude inflation consistently. We summarize eight formulas for adjusting discount rates for income taxes and inflation in a simple three-step process. A one-page figure is presented that can be used as a stand-alone tool for correctly adjusting discount rates. South. J. Appl. For. 24(4):193–195. The discount rate is extremely important in evaluating the financial attractiveness of forestry investments. In this article, we define the “discount rate” as the minimum rate of compound interest an investor considers acceptable for a specific project. This rate of interest is sometimes called the guiding rate, the hurdle rate, the alternative rate of return, or the cost of capital. Discount rates are sometimes adjusted—increased or decreased—to account for investment characteristics such as risk, liquidity, and duration. Here we emphasize discount rate adjustments for inflation and income taxes. Our purpose is to promote consistency in accounting for these factors in forestry investment analysis. In a given analysis, foresters should ensure that the discount rate and all costs and revenues are either before or after taxes, and that inflation is either included or excluded consistently. Relatively common inconsistencies in forestry investment analysis include: • Applying a before-tax discount rate to after-tax costs and revenues; and • Comparing the rate of return estimated for a forestry investment using today’s timber prices (an uninflated rate) to interest rates that can be earned on corporate bonds or bank certificates of deposit (inflated rates). NOTE: Approved for Publication as Journal Article No. FO 134 of the Forest and Wildlife Research Center, Mississippi State University. Steven H. Bullard is the corresponding author, and he can be reached at Phone: (662) 325-2781; Fax:(662) 325-8726; E-mail: sbullard@cfr.msstate.edu. Manuscript received September 13, 1999, accepted March 9, 2000. Copyright © 2000 by the Society of American Foresters. In this article we present a one-page summary of eight formulas that can be used to adjust discount rates for income taxes and inflation. The formulas are very useful in ensuring consistency in forestry investment analysis. An important caution is needed, however. The eight formulas we summarize should not be used to adjust the “return on investment” or “internal rate of return” for a specific investment project. The relationship between the beforeand after-tax internal rate of return for a project is affected by many factors, including tax credits, deductions, cash-flow timing, and other factors specific to the project. Our experience in undergraduate education and in continuing education of professional foresters indicates that this one-page summary of eight formulas is a very useful tool for applied forestry investment analysis. Readers interested in derivations of the formulas summarized here may consult Gregersen (1975), Gunter and Haney (1984), Bullard and Straka (1998), Bullard et al. (2000), Campbell and Colletti (1990), Harou (1983), and Klemperer (1979). Adjusting Discount Rates Depending on the specific project, investments may be evaluated with or without inflation, and before or after taxes—so there are four potential choices for the discount rate. These choices are represented in the shaded diagram quadrants in the upper part of Figure 1. For consistency, the discount rate and all of the costs and revenues associated with a specific investment must be in the same quadrant of this diagram. That is, the discount rate and all costs and revenues must either be on a before-tax or an after-tax basis, and they must either be in nominal (inflated) or real terms.