Lecture (11)

Feasibility
*Investment appraisal and Taxation:-
-We will deal with the impact of taxation on investment project’s cash
flow and their subsequent evaluation.
-Management is taking decisions to maximize the wealth of
shareholders. Based on this, and as far as investment appraisal is
concerned, we may evaluate the after tax cash flows.
Ex: assume we have for project (A)
before-tax income $100,000
after-tax income $40,000
Here, the management will evaluate the after-tax income ($40,000) as
dividends that will be paid to the shareholders.
*The impact of taxation through the United Kingdom (UK) corporate tax

system:-
-There are 3 ways for UK taxes impact on projects appraisal:-
(1) Tax relief is available on capital expenditure through the system of
capital or writing down allowances.
-Capital expenditure is expenditure that used to buy fixed assets or to
add the value to the existing fixed asset in order to generate future benefits.
Example: the company will buy assets with $100,000 to generate
$10,000 revenues with expenses $6,000. Here the tax relief will be upon
(10,000 – 6,000) $4,000
-Writing down allowances will spread the tax relief over the project’s life
in accordance with a specific schedule.
(2)A tax liability will arise on any taxable profit generated by the project.
-If revenues are $10,000 and expenses are $4,000 ,the net income will be
$6,000. Assuming the tax rate was 20%, the payable tax will be
(0.2×6000) $1200, and the taxable profit will be (6000 -1200) $4800.

Dr. Cr.
Income Summary $6000
Retained earnings $6000

Dr. Cr.
Retained Earnings $1200
Tax payable $1200
(3) If the project is financed with help of debt capital then there will be
tax relief available on the interest payments.
-We have two types of money to invest in projects (capital and loans).
1-Capital that related to[shares]that owned by[shareholders](who receive dividends)
2- Loan that related to[bonds]that owned by [Bondholders](who receive interests)
There will be tax relief on these interests that Bondholders receive.
*Financing cash flows:-
-The project can be financed internally (capital) or externally (loan).
-The basic philosophy of the approach of investment appraisal and the-
NPV technique in particular will be outlined now. This approach is that
the financing method, and hence all the cash flows associated with the-
financing method, including interest payments, divided payments and
loan repayments, can be ignored. This is because, in effect, they are
implicitly taken into account in the discount rate used in the NPV analysis.
Example(1): Assume that a company wants to buy a truck at $1500, but
it will be used in company’s operations and will yield after cash
operating cost $350 per year. The services life is 3 years and the-
company can borrow the truck price from a bank at 12% interest rate.

-This can be considered into 2 methods:-

(1) To ignore the interest payments and loan payments and to

concentrate on cash flows only as follows:-
NPV = –1500 + 350 A3-0.12
= –1500 + (350×2.4018)
= –1500 + 840.63
NPV = –659.37
-You may think that this does not represent the true company cash flow
,as effectively the bank (not the company) buys the machine, but this
standpoint is not true.

[Notice that we used here the Annuities (A3-0.12) to discount a constant

amount of cash ($350) that arises for a given number of consecutive
years. To find the present value of annuity look at Table C page 668].
(2) To calculate the interest payments and the loan repayment as follows:-
-From the company’s standpoint the true cash flows associated with
the project are:-

Year 0 1 2 3
Interest ‫ـــــــ‬ –180 –180 –180
Loan repayment ‫ـــــــ‬ ‫ــــــــ‬ ‫ــــــــ‬ –1500
Net revenue ‫ـــــــ‬ +350 +350 +350
Net cash flow 0 +170 +170 -1330
-We will discounted the net cash flow at rate 10%
NPV= +170 A2-0.12 – 1330 (1.12)-3
= (+170×1.6901) – (1330×0.7118)
= 287.32 – 946.69
NPV= – 659.37

-The two methods (1) and (2) are similar because the present value of
the financing cash flow always equals the amount of the finance. By
meaning that the present value of the bank loan cash flow equals the
amount of bank loan.
-Therefore, in the method (1) of original NPV analysis, the financing
method is not ignored because the project’s outlay represents
the present value of the financing method.
-Finally, the NPV analysis outlay would implicitly represent the present
value of all the financing cash flows, however the project was financed.