Chapter 4 – Further aspects of discounted

cashflows
Chapter agenda

Use of real
interest rate in
Real Vs Nominal NPV
Interest rate Use of money
Impact of
interest rate in
Inflation Specific Vs NPV
General inflation
Accounting for rate
Chapter 4
working capital

Capital
Impact of tax
allowances

Impact of inflation on interest rates

Inflation is simply the general increase in prices of goods and services. Due to inflation real
value of money falls. This means there an impact on the interest rate/discount factor

Nominal rate Vs Real rate of interest

The relationship between the nominal interest rate and real interest rate can be highlighted
using the following equation.

(1 + 𝑟)
(1 + 𝑖) =
(1 + ℎ)

I – nominal interest rate

R – real interest rate
H – inflation rate

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Example – Real rate and Nominal rate

You invest $10,000 in an account that pays 12% per annum. Inflation rate 5%. What is the
real return on the investment?

Dealing with inflation

There are two methods to deal with inflation.
1. Using the nominal rate (money rate)
2. Using the real rate

This can be illustrated with the following example.

Example - Inflation using the money rate and real rate

A project has the following cashflows before accounting for inflation. The company’s money
discount rate is 15%

Year Cashflow ($)

0 (1000)
1 450
2 350
3 300

Calculate the NPV using

1. Real cash flows and real discount rate

2. Money cashflows and money discount rate

Use of specific inflation rates

In the real world, inflation does not affect all cashflows to the same degree. There may be
times when a specific rate of inflation will be applicable for costs or revenues. E.g. wage
inflation of 5%, material cost inflation of 3% etc.

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If in a question, there is only one inflation rate

Then similar to the example above, it is possible to calculate cashflows in money terms or
real terms

If in a question, there are multiple inflation rates

Then, cashflows must be evaluated only using money rates.

This can be illustrated with the following example

Example – Multiple inflation rates

A company is considering an investment which requires $15,000 today for a cost-saving

initiative. Due to the project, the company expects savings (in real terms) on wage costs of
$4000 and on material costs of $2000.

The company expects the following inflation rates per annum into the next 3 years

Wage costs 10%

Material costs 5%
General prices 6%

The cost of capital of the company, in real terms, is 8%.

Evaluate the project, assuming that the machine has a life of five years and no scrap value.

Dealing with TAX in NPV Calculations

All companies have to pay taxes to the government.

When it comes to investment appraisal, tax charge on the company’s profits is a relevant
cash flow, hence it should be accounted for in the NPV analysis.

The following must be considered in calculating taxes.

• Operating cashflows are taxed at the corporate tax rate.

• Investment spending attracts tax-allowable depreciation

• Tax is typically paid one year after it is incurred (unless otherwise stated)

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What is Tax – allowable depreciation?
In taxation, the cost of an asset can be deducted from TAXABLE PROFIT as depreciation in
the form of tax-allowable depreciation.

Tax-allowable depreciation (aka Writing Down Allowances WDA) is calculated on the written
down value of the asset either using straight-line method or the reducing balance method.

This is calculated on every year of ownership except the year of disposal.

In the year of disposal or scrap, A BALANCING ALLOWANCE (BA) or BALANCING CHARGE is

arisen.

This is calculated as

Cost of the asset XX

Cumulative tax-allowable depreciation (X)
Written down value of the asset XX
Disposal value (X)
Balancing allowance XX

Example – Balancing allowance

A project that has a life of 4 years requires a company to purchase machinery for $100,000
now. At the of the project, the machinery is sold. Tax is payable at 20%, one year in arrears,
and tax-allowable depreciation is available at 25% reducing balance.

Required:

a) Calculate the tax depreciation and the resulting tax savings for each year if the
proceeds on disposal of the asset are $20,000.

b) How would your answer change if the asset were sold for $2,000?

c) Calculate the NPV of the project assuming that it generates a net cash flow of
$80,000 (before interest & tax) each year and cost of capital rate of 10%.

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How to account for working capital in NPV calculations?
Working capital = Short-term assets – Short-term liabilities

When undertaking a new project, in addition to the cost of the investment, funds are
required to invest in working capital.

Accounting for working capital

• The initial investment in working capital is considered a cash outflow
• During the project, if there is an increase in working capital, then it is a cash outflow
• During the project, if there is a decrease in working capital, then it is a cash inflow
• At the end of the project, working capital is released & this is a cash inflow

Calculating working capital

Step 1: Calculate the absolute amounts of working capital for each
Step 2: Estimate the incremental cash flows required each year

Example – Working capital

A company is undertaking a 4-year project where net cashflows in year 1 are expected to be
$200,000. This is expected to grow at 10% per annum till the end of the project.
The company expects the working capital requirement to be 10% of the annual this needs to
be invested at the start of each year.

Calculate the working capital flows for incorporation into the NPV calculation.

Tackling NPV questions with inflation, tax and working capital

In tackling such questions, the following must be considered.

• Make sure to inflate costs, revenues & disposal values by general/specific inflation
rates.

• Make sure to calculate working capital on the inflated values unless otherwise
stated.

• Use money rates to discount the cash post-tax cash flows.

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Example – Inflation, tax and working capital

Company ABC is considering a project which requires the purchase of machinery for $500
million today. ABC expects to dispose of the machinery at $100m at the end of the project.
It expects to sell 2.5, 5 and 3 million units in each of the next 3 years.

The selling price per unit is expected to be $120 and the variable cost is $40 per unit.
Tax rate is 30% which is paid one year after the accounting period in concern.

The working capital requirement is 15% of annual sales which must be invested at the start
of each year. Tax-allowable depreciation is 25% based on the reducing balance method.
The company has a real required rate of return of 7%. General inflation is predicted to be
3% per year but the selling price is expected to inflate at 4% and variable costs by 5% per
year.

Determine the NPV of the project. (All numbers must be rounded off to the nearest million)

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