STRATEGIC FINANCIAL

MANAGEMENT
INVESTMENT APPRAISAL – TAXATION AND INFLATION
Dayana Mastura Baharudin
 So far, in looking at project appraisal,
we have ignored taxation

However, payments of tax, or

reductions in tax payments, are
TAXATION relevant cash flows and ought to be
considered in Discounted Cash Flow
(DCF) analysis
The existence of tax on corporate
profits gives rise to two cash flows that
need to be taken into account in
project appraisal
Tax On Corporate Profits Gives Rise To Two
Cash Flows

Total Tax Cash

Flow

Tax payments Tax benefits from

(benefits) on tax allowable
operating profits/ depreciation on
(losses) capital expenditure
 The tax rate to be applied will
be give in the question

Corporation Tax on profits will either be

payable in the same year as
Tax on Profits the taxable profits are earned
or in the following year;

The appropriate timing to

apply will be specified in the
question given
 Where tax-allowable
depreciation (also called capital
Tax allowable depreciation is not
allowance or writing down
the same as the accounting
allowance) can be claimed, this
depreciation charge for the
will reduce taxable profits, and
purpose of reporting profit in the
the consequent reduction in a
financial statements
tax payment should be treated
as a cash saving

Tax allowable depreciation may

Tax Allowable be applied as a straight-line

depreciation (the same amount
each year) or on a reducing
Assuming a zero disposal value,
in the final year of an asset’s
life, Tax Allowable Depreciation

Depreciation balance basis based on the

‘written down value’ (WDV) of
the asset at the start of year
will reduce the WDV of the asset
to zero.

The final Tax Allowable

Depreciation claim is called a
balancing allowance and means
that the full capital cost of the
asset is claimed over the asset’s
useful life.
 Tax allowable depreciation is available on the
cost of plant and machinery at a rate of 25% on
the written down value (WDV) (ie. On a
reducing balance basis)

A company purchases machinery costing

Example – $80,000 with a 4-year useful life and zero

residual value

Tax Allowable
Depreciation Required:

Calculate the Tax Allowable Depreciation and

the Written Down Value for Year 1 to Year 4
showing all calculations clearly.
Solution – Tax Allowable Depreciation

Year 1 2 3 4
WDV b/f ($) 80,000 60,000 45,000 33,750
Tax Allowable 20,000 (25% x 15,000 (25% x 11,250 (25% x 33,750
Depreciation 80,000) 60,000) 45,000) (balancing
allowance)
WDV c/f ($) 60,000 (80k-20k) 45,000 (60k-15k) 33,750 (45,000 – 0
11,250)
• When the asset is eventually sold, the
balancing allowance is based on the
written down value at the start of the year
LESS the disposal value obtained from the

Impact on
sale of the asset

Disposal
Value
 Continuing from the previous
example

Example –
Impact of
disposal value
If the asset is sold at the end of year
4 for $25,000 the tax allowable
depreciation in year 4 would change
(the other year’s tax allowable
depreciation are unaffected)
Solution- Impact of Disposal Value 1

Year 4
WDV b/f ($) 33,750
Disposal Value (25,000)
Tax Allowable Depreciation (balancing 8,750
allowance)
WDV c/f ($) 0
Solution – Impact of Disposal Value 2

Year 4
WDV b/f ($) 33,750
Disposal Value 40,000
No Tax allowable depreciation exists (6,250)
(balancing charge) This amount will be
taxed by the authorities
WDV c/f ($) 0
Tax saved on Tax Allowable Depreciation

Tax allowable depreciation is not a cash flow

However, the tax saved due to the tax allowable depreciation is a cash flow and this need to be
recognized

The cash saving on tax-allowable depreciation is calculated by multiplying the amount of the tax-
allowable depreciation by the tax rate

If tax cash flows occur in the year following the year in which the item giving rise to the tax
occurs, the cash flow for the tax saving from tax-allowable depreciation will occur in the year
following the year in which the allowance is claimed
Illustration of Tax Allowable Depreciation –
Tax Saved
•Tax savings may occur a year
after the Tax Allowable
Depreciation is claimed
depending on whether
Year 1 2 3 4
•tax on profits is payable in the
same year as the taxabale Tax Allowable 20,000 15,000 11,250 8,750
profits are earned , or in the Depreciation ($)
following year. Tax Saved ($) 4,000 (20% 3,000 (20% 2,250 (20% 1,750 (20%
•Following from the previous x 20,000) x 15,000) x 11,250) x 8,750)
example with impact of
disposal value, the rate of tax
on profit is 20%
Inflation

• Real: The term ‘real’ when applied to cash flows or to the cost of
capital, means based on current price levels
Inflation

• Nominal: The term ‘nominal’ when applied to cash flows or to the

cost of capital, means after adjusting for the impact of expected
inflation
 Inflation has 2 impacts on the Net
Present Value (NPV);

Impact of Cash flows – Cash flows rise due to

inflation, making the project more
inflation on attractive

project Discount factor – The Cost of capital

appraisal rises, making the project less attractive

Present value – The net impact on the

NPV may be minimal
 Example

Bistro Co is a brewing company trying to decide whether to buy a new bottling machine
for $10m to save on rental costs which are currently $6.6m p.a
Running costs for the new machine would be $1.2m p.a

The bottling machine has no resale value and has an expected life of three years

All cash flows are quoted in current prices (i.e in real terms) and are expected to rise
in line with the consumer price index (or CPI, a measure of inflation) at 5.26% pa
Bistro’s real cost of capital is 14% and its nominal cost of capital is 20%. Ignore tax

Required – Evaluate whether the new bottling machine should be purchased

Solution

Year 0 1 2 3
Running costs (x (1.26) (1.33) (1.40)
1.0526 p.a)
Savings (x 6.95 7.31 7.70
1.0526 p.a)
Purchase costs (10)
Net (10) 5.69 5.98 6.30
Discount factor 0.833 0.694 0.579
@ 20%
Present Value (10) 4.74 4.15 3.65
(PV)
Net Present 2.54
Value (NPV)