Strategic Financial Management - Investment Appraisal: Tax and Inflation

1. STRATEGIC FINANCIAL
MANAGEMENT
INVESTMENT APPRAISAL – TAXATION AND INFLATION
Dayana Mastura Baharudin

2. TAXATION
So far, in looking at project appraisal,
we have ignored taxation
However, payments of tax, or reductions
in tax payments, are 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

3. Tax On Corporate Profits Gives Rise To Two
Cash Flows
Total Tax Cash Flow
Tax payments
(benefits) on
operating profits/
(losses)
Tax benefits from
tax allowable
depreciation on
capital expenditure

4. Corporation
Tax on Profits
The tax rate to be applied will
be give in the question
Tax on profits will either be
payable in the same year as
the taxable profits are earned
or in the following year;
The appropriate timing to
apply will be specified in the
question given

5. Tax Allowable
Depreciation
Where tax-allowable
depreciation (also called capital
allowance or writing down
allowance) can be claimed, this
will reduce taxable profits, and
the consequent reduction in a
tax payment should be treated
as a cash saving
Tax allowable depreciation is not
the same as the accounting
depreciation charge for the
purpose of reporting profit in the
financial statements
Tax allowable depreciation may
be applied as a straight-line
depreciation (the same amount
each year) or on a reducing
balance basis based on the
‘written down value’ (WDV) of
the asset at the start of year
Assuming a zero disposal value,
in the final year of an asset’s
life, Tax Allowable Depreciation
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.

6. Example – Tax
Allowable
Depreciation
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
$80,000 with a 4-year useful life and zero
residual value
Required:
Calculate the Tax Allowable Depreciation and
the Written Down Value for Year 1 to Year 4
showing all calculations clearly.

7. Solution – Tax Allowable Depreciation
Year 1 2 3 4
WDV b/f ($) 80,000 60,000 45,000 33,750
Tax Allowable
Depreciation
20,000 (25% x
80,000)
15,000 (25% x
60,000)
11,250 (25% x
45,000)
33,750
(balancing
allowance)
WDV c/f ($) 60,000 (80k-20k) 45,000 (60k-15k) 33,750 (45,000 –
11,250)
0

8. Impact on
Disposal
Value
• 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
sale of the asset

9. 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)
Continuing from the previous
example

10. Solution- Impact of Disposal Value 1
Year 4
WDV b/f ($) 33,750
Disposal Value (25,000)
Tax Allowable Depreciation (balancing
allowance)
8,750
WDV c/f ($) 0

11. Solution – Impact of Disposal Value 2
Year 4
WDV b/f ($) 33,750
Disposal Value 40,000
No Tax allowable depreciation exists
(balancing charge) This amount will be
taxed by the authorities
(6,250)
WDV c/f ($) 0

12. 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

13. Illustration of Tax Allowable Depreciation –
Tax Saved
• Tax savings may occur a year
after the Tax Allowable
Depreciation is claimed
depending on whether
• tax on profits is payable in
the same year as the taxabale
profits are earned , or in the
following year.
• Following from the previous
example with impact of
disposal value, the rate of tax
on profit is 20%
Year 1 2 3 4
Tax Allowable
Depreciation ($)
20,000 15,000 11,250 8,750
Tax Saved ($) 4,000 (20%
x 20,000)
3,000 (20%
x 15,000)
2,250 (20%
x 11,250)
1,750 (20%
x 8,750)

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

15. 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

16. Impact of
inflation on
project
appraisal
Inflation has 2 impacts on the Net
Present Value (NPV);
Cash flows – Cash flows rise due to
inflation, making the project more
attractive
Discount factor – The Cost of capital
rises, making the project less attractive
Present value – The net impact on the
NPV may be minimal

17. 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

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