Depreciation expenses under inflation: The profitability of a project can change in the presence of inflation.  One of the ways that this can happen is due to the effect of inflation on depreciation charges.

Depreciation expense for each year during the life of the project is computed using year zero dollars.  Under inflation, revenues as well as other expenses will reflect the effect of inflation; they will increase under inflation.  Depreciation expenses however, remain unchanged as they are computed in year zero using some depreciation schedule.    Due to this decline in the real value of depreciation, the taxable income for the project will increase and so will taxes.  Because of the higher taxes, in "real" terms, the net present worth can decrease.  This decrease in the net present worth of projects with depreciable assets is due to the additional taxes that are now due.  The additional tax is also known as the inflation tax.  Example 13.9 illustrates this principle.

Borrowed funds under inflation: The effect of inflation on borrowed funds is exactly the opposite of its effect on depreciation.  The effect on borrowed funds can actually be beneficial resulting in gains in the present worth of the project.    This occurs because repayment of borrowed funds is based on the historical contract amount.  The payment per period remains unchanged.  The real worth of future payments decline because of inflation.  The effect on the net worth of the project can thus be positive.  Example 13.11 illustrates this concept.