INVESTMENT APPRAISAL – TAXATION & INFLATION

Inflation and capital investment decisions

Inflation can have a serious effect on capital investment decisions, both by
reducing the real value of future cash flows and by increasing their
uncertainty. Future cash flows must be adjusted to take account of any
expected inflation in the prices of goods and services in order to express them
in nominal (or money) terms, i.e., in terms of the actual cash amounts to be
received or paid in the future. Nominal cash flows are discounted by a
nominal cost of capital using the net present value method of investment
appraisal.

As an alternative to the nominal approach to dealing with inflation in

investment appraisal, it is possible to deflate nominal cash flows by the
general rate of inflation in order to obtain cash flows expressed in real terms,
i.e., with inflation stripped out. These real cash flows can then be discounted
by a real cost of capital to determine the net present value of the investment
project. Whichever method is used, whether nominal terms or real terms, care
must be taken to determine and apply the correct rates of inflation to the
correct cash flows.

(1 + Nominal cost of capital) = (1 + Real cost of capital) * (1 + Inflation rate)

Where, Nominal cost of capital is expressed by i

Real cost of capital is expressed by r

Inflation is expressed by h

(1+i) = (1+r) + (1+h)

For example, if the nominal cost of capital is 15 per cent and the rate of
inflation is 9 per cent, the real cost of capital will be 5.5 per cent:

(1 + 0.15)/(1 + 0.09) = 1.055

This above formula is known as Fisher equation

The Fisher equation is a concept in economics that describes the relationship

between nominal and real interest rates under the effect of inflation. The
equation states that the nominal interest rate is equal to the sum of the real
interest rate plus inflation.

The Fisher equation is often used in situations where investors or lenders ask
for an additional reward to compensate for losses in purchasing power due to
high inflation.

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Test your understanding 1 – Money and real methods

Storm Co is evaluating Project X, which requires an initial investment of

$50,000. Expected net cash flows are $20,000 per annum for four years at
today’s prices. However, these are expected to rise by 5.5% pa because of
inflation. The firm’s money cost of capital is 15%.
Find the NPV by:
(a) Discounting money cash flows
(b) Discounting real cash flows

Test your understanding 2 – Money and real methods

A project has the following cash flows before allowing for inflation, i.e. they are
stated at their T0 values.
Timing Cash flow
$
0 (750)
1 330
2 242
3 532

The company’s money discount rate is 15.5%. The general rate of inflation is
expected to remain constant at 5%.
Evaluate the project in terms of:

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(a) Real cash flows and real discount rates

(b) Money cash flows and money discount rates.

Specific and general inflation rates

The TYUs given above had all cash flows inflating at the general rate of
inflation. In practice, inflation does not affect all costs to the same extent. In
some investment appraisal questions you may be given information on more
than one inflation rate. In these situations, you will have information on both
specific inflation rates and general inflation rates.

Specific and general inflation rates

If there is one rate of inflation in the question both the real and money method
will give the same answer. However it is easier to adjust one discount rate,
rather than all the cash flows over a number of years. This is particularly true
where the cash flows are annuities. The real method is the only possible
method where they are perpetuities.
Although it is theoretically possible to use the real method in questions
incorporating tax, it is extremely complex. It is therefore much safer (and
easier) to use the money/nominal method in all questions where tax is taken
into account.

To use the real method when cash flows inflate at different rates (specific
rates) is extremely complex and would involve a lot of calculations. It is
therefore advisable to always use the money method in these situations. This
involves:
 Inflating the cash flows at their specific inflation rates

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 Discounting using the money rate

Very often the money rate will not be given in the question but will need to be
calculated. This should be done using the real rate and the general inflation
rate.

Test your understanding 3 – General and specific inflation rates

A company is considering a cost saving project. This involves purchasing a

machine costing $7,000, which will result in annual savings (in real terms) on
wage costs of $1,000 and on material costs of $400.
The following forecasts are made of the rates of inflation each year for the
next five years:
Wage costs 10%
Material costs 5%
General prices 6%
The cost of capital of the company, in real terms, is 8.5%.
Evaluate the project, assuming that the machine has a life of five years and
no scrap value.

Dealing with tax in NPV calculations

Since most companies pay tax, the impact of corporation tax must be
considered in any investment appraisal.

The impact of taxation on cash flows

Corporation tax charged on a company’s profits is a relevant cash flow for
NPV purposes. It is assumed, unless otherwise stated in the question, that:

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 Operating cash inflows will be taxed at the corporation tax rate

 Operating cash outflows will be tax deductible and attract tax relief at the
corporation tax rate
 Investment spending attracts tax allowable depreciation
 The company is earning net taxable profits overall (this avoids any issues
of carrying losses forwards to reduce future taxation).
 Tax is paid one year after the related operating cash flow is earned (unless
told otherwise

Tax allowable depreciation

For tax purposes, a business may not deduct the cost of an asset from its
profits as depreciation (in the way it does for financial accounting purposes).
Instead the cost must be deducted from taxable profits in the form of tax
allowable depreciation. The basic rules are as follows:
 Tax allowable depreciation is calculated based on the written down value
of the assets (this will either be on a reducing balance or straight-line basis
– read the question carefully)

 The total amount of tax allowable depreciation given over the life of an
asset will equate to its fall in value over the period (i.e. the cost less any
scrap proceeds)

 Tax allowable depreciation is claimed as early as possible

 Tax allowable depreciation is given for every year of ownership except
the year of disposal

 In the year of sale or scrap a balancing allowance (BA) or balancing

charge arises (BC).

$
Original cost of asset X
Cumulative tax allowable depreciation claimed (X)
–––
Written down value of the asset X
Disposal value of the asset (X)
–––
Balancing allowance or balancing charge X

Test your understanding 4 – Balancing allowance or charge

An asset is bought for $10,000 and will be used on a project for four years
after which it will be disposed of. Tax is payable at 30%, one year in arrears,
and taxallowable depreciation is available at 25% reducing balance.
Required:
A. Calculate the taxallowable depreciation and hence the tax savings for
each year if the proceeds on disposal of the asset are $2,500.
B. How would your answer change if the asset was sold for $5,000?

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C. If net trading income from the project is $8,000 pa, based on your answer
to part (a) and a cost of capital of 10%, calculate the NPV of the project.

For tax purposes care must be taken to identify the exact time of asset
purchase relative to the accounting period end. However, unless you are
told otherwise in the exam you should assume that an asset is
purchased on the first day of an accounting period (T0) and that the first
amount of tax allowable depreciation is given one year later at T1.

Test your understanding 5

A company buys an asset on the first day of the accounting period for
$26,000. It will be used on a project for three years after which it will be
disposed of. Tax is payable at 30% one year in arrears, and tax allowable
depreciation is available at 25% reducing balance.
A. Calculate the taxallowable depreciation and hence the tax savings for
each year if the proceeds on disposal of the asset are $12,500.
B. If net trading income from the project is $16,000 pa and the cost of
capital is 8% calculate the NPV of the project.

Incorporating working capital

As activity levels rise as a result of investment in non-current assets, the
company’s levels of trade receivables, inventories of raw materials and
inventories of finished goods will also increase. These increases will be
financed in part by increases in trade payables. This incremental increase in
working capital will represent a cash outflow for the company and is a relevant
cash flow which must be included in the investment appraisal process. Further
investment in working capital may be needed, as sales levels continue to rise,
if the problem of undercapitalization or overtrading is to be avoided

The treatment of working capital is as follows:

 initial investment is a cost at the start of the project
 if the investment is increased during the project, the increase is a relevant
cash outflow
 at the end of the project all the working capital is ‘released’ and treated as
a cash inflow.

To calculate the working capital cash flows you should:

Step 1: Calculate the absolute amounts of working capital needed in each
period
Step 2: Work out the incremental cash flows required each year

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Test your understanding 6 – Working capital

A company expects sales for a new project to be $225,000 in the first year
growing at 5% pa. The project is expected to last for 4 years. Working capital
equal to 10% of annual sales is required and needs to be in place at the start
of each year.
Calculate the working capital flows for incorporation into the NPV calculation.

If you have a question including both working capital and inflation, you should
always adopt the money method (inflating the cash flows). Calculate the
actual money amount of the factor on which working capital is dependent
(often sales or contribution) before calculating the working capital
requirements.

Test your understanding 7 – Working capital

A company anticipates sales for the latest venture to be 100,000 units per
year. The selling price is expected to be $3 per unit in the first year, inflating
by 8% pa over the three-year life of the project. Working capital equal to 10%
of annual sales is required and needs to be in place at the start of each year.
Calculate the working capital flows.

Test your understanding 8 – Working capital

Gunning Industries is considering investment in a new machine which has a

five-year life. The investment in the new machine would also require an
immediate increase in working capital of $35,000. Gunning is subject to a
40% corporate tax rate and has a 10% weighted average cost of capital

What is the overall discounted cash flow effect on Gunning Industries’ working
capital investment over the life of the new machine?

Dealing with questions with both tax and inflation

Combining tax and inflation in the same question does not make it any more
difficult than keeping them separate.
Questions with both tax and inflation are best tackled using the money
method.
 Inflate costs and revenues, where necessary, before determining their
tax implications.
 Ensure that the cost and disposal values have been inflated (if
necessary) before calculating taxallowable depreciation.
 Always calculate working capital on these inflated figures, unless given.
 Use post tax money discount rate

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Test your understanding 9 – NPV with tax, inflation and working capital

CBS Co is considering a new investment which would start immediately and

last four years. The company has gathered the following information:

Asset cost – $160,000

Annual sales are expected to be 30,000 units in Years 1 and 2 and will then
fall by 5,000 units per year in both Years 3 and 4.

The selling price in first-year terms is expected to be $4.40 per unit and this is
then expected to inflate by 3% per annum. The variable costs are expected to
be $0.70 per unit in current terms and the incremental fixed costs in the first
year are expected to be $0.30 per unit in current terms. Both of these costs
are expected to inflate at 5% per annum.

The asset is expected to have a residual value (RV) of $40,000 in money

terms.
The project will require working capital investment equal to 10% of the
expected sales revenue. This investment must be in place at the start of each
year.

Corporation tax is 30% per annum and is paid one year in arrears. 25%
reducing balance writing-down allowances are available on the asset cost.
General inflation is 4% and the real cost of capital is 7.7%

$12,000 has already been spent on initial research.

Required: Calculate the NPV of the proposed investment.

Test your understanding 10 – NPV with tax, inflation and working

capital

UGL Ltd (UGL) manufactures domestic solar panels and has a financial year
end of 31 December. Its directors are now considering expanding UGL’s scale
of operations via an initiative called ‘Project North’.

If ‘Project North’ is to proceed, then UGL would have to invest in new capital
equipment which would cost $1.3 million and be purchased on 31 December
20X1. Because of the fast rate of technological change in the solar panel
industry, UGL’s directors estimate that ‘Project North’ would enjoy a three-
year period of competitive advantage (20X2–20X4).

UGL has paid for market research which produced the following estimates for
‘Project North’:

Year to 31 December 20X2 (all figures expressed in December 20X1 prices)

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Total sales $2,200,000

Total variable costs $1,200,000

Total fixed costs (including interest paid of $17,000) $427,000

Increase in sales volume in 20X3 and 20X4 10%

Inflation rates:

Sales prices 5%
All costs 8%

Working capital (to be placed at the start of each trading year) 10% of sales

Trade in value of capital equipment (in December 20X4 prices) $600,000

Capital allowances

UGL’s machinery and equipment attracts capital allowances, but is and will be
excluded from the general pool. The equipment attracts 18% (reducing
balance) capital allowances in the year of expenditure and in every
subsequent year of ownership by the company, except the final year. In the
final year, the difference between the machinery’s written down value for tax
purposes and its disposal proceeds will be either:

 treated by the company as an additional tax relief, if the disposal

proceeds are less than the tax written down value; or

 be treated as a balancing charge to the company, if the disposal

proceeds are more than the tax written down value.

Other information

 UGL uses a post-tax money weighted average cost of capital of 14%.

 UGL’s directors would like to assume that the corporation tax rate will
be 17% for the foreseeable future and tax will be payable in the same
year as the cash flows to which it relates.

 Unless otherwise stated all cash flows occur at the end of the relevant
trading year.

Requirements

A. Calculate the net present value of the ‘Project North’ initiative at 31

December 20X1 and advise UGL’s directors whether they should proceed
with it.