Chapter V
Allowing for inflation
and taxation
Allowing for inflation and taxation
Topic List
• Inflation
• Taxation
• NPV layout
Slide 2
Inflation
• When a company makes a long-term
investment, there will be costs and benefits for
a number of years.
• In all probability , the future cash flows will be
affected by inflation in sales prices and inflation
in costs. So fare the explanation of DCF
investment appraisal has ignored inflation.
Slide 3
Occasions when inflation is ignored
In practice, it is common to ignore inflation when
carrying out DCF analysis for investments
appraisal. Inflation can be ignored if it can be
assumed that:
• There will be no inflation in prices and costs, or
• It is impossible to predict what inflation will be,
but the effects of inflation will be insignificant
• All cash flows, for benefits and cost , will have
exactly the same rate of inflation.
Slide 4
Occasions when inflation is ignored
• It is certainly difficult to predict what the rate of
inflation will be over the next few years, and
this is probably why inflation is normally ignored
for DCF analysis.
• However, inflation might be a significant factor
in some investments.
• Inflation should be taken into consideration.
Slide 5
The normal rules for inflation in DCF analysis
• The cost of capital used in DCF analysis is
normally a ‘money’ cost of capital.
• This is a cost of capital calculated from
current market returns and yields.
Slide 6
Example (The normal rules for inflation in DCF analysis)
• A company is considering an investment in an item of
equipment costing $150,000. The equipment would be
used to make a product. The selling price of the
product at today’s prices would be $10 per unit, and
the variable cost per unit (all cash costs) would be $6.
Slide 7
Example
• At today’s prices, it is expected that the equipment will be sold
at the end of year 4 for $10,000. There will be additional fixed
cash overheads of %50,000 each year as a result of the project,
at today’s price levels.
• The company expects prices and cots to increase due to
inflation at the following annual rates:
• The company’s money cost of capital is 12%. Ignore taxationl.
Required: Calculate the NPV of the project.
Slide 8
Using the real cost of capital
• The cost of capital given for use in DCF analysis
is normally a ‘money’ rate of return (also
known as a nominal rate of return).
• The money rate of return should be used to
discount money cash flows which haven
adjusted to take into account inflation increase.
• An alternative approach to DCF analysis is to
discount real cash flows using a real cost of
capital. Real cash flows are shown at today’s
prices.
Slide 11
Real cost and money cost
• A money cost is a cost that include an allowance for
inflation.
• A real cost is a cost that excludes the effects of
inflation. Real costs have to be expressed in term of
prices at a given date. In DCF analysis this will
normally be ‘today’s prices’.
• For example suppose that inflation for the next two
years is expected to be 4% per year. If a cost at the
end of year 2 is $1,000 at today’s prices, it will be
$1,082 after allowing for inflation. In this example,
$1,000 is the real cost and $1,082 is the money cost.
Slide 12
Real cost and money cost
• The same applies to the cost of capital. A money cost of capital
is expressed in terms of current investment rates in the market,
but these rates already make allowance fore exceptions of
future rates of inflation.
• The real rate of return on investment is the money market rate
with inflation taken out.
• A real rate of return can be calculated using the relationship
(1+ money rate) = (1+ real rate) x (1+ inflation rate)
• Example:
If a company has a cost of capital of 12% and inflation is 5%
(1 + 0.12) = (1 + real rate) x (1+0.05)
So the real rate = 1.12/1.05 – 1 = 6.67%
Slide 13
Example (using the real rate of return for DCF analysis)
Slide 14
Which method to use for DCF analysis with inflation?
• When inflation is taken into consideration in
investment appraisal, the normal method of analysis is
to use money cash flows and the money cost of
capital.
• This is because different items of cost or revenue are
likely to have differing rates of inflation.
• When this happens it becomes a complex
mathematical process to adjust all cash flows to a real
value.
Slide 17
Which method to use for DCF analysis with inflation?
The real cost of capital and real cash flows should
only be used :
• When all items are expected to have the same
rate of inflation, and
• You are asked to use real costs and the real
cost of capital by an examination question.
Slide 18
Taxation
• In project appraisal, cash flows arise due to the
effects of taxation.
• When investment results in higher profits, there
will be higher taxation.
• Tax cash flows should be included in DCF
analysis. In DCF analysis it is normally assumed
that tax is payable on the amount of cash profits
in any year.
Slide 19
Taxation
• For example, if taxation on profits is 25% and a
company earns $10,000 cash profit each year from an
investment, the pre-tax cash inflow is $10,000, but
there is a tax payment 2,500.
• Similarly, if an investment results in lower profits, tax
is reduced. For example, if an investment causes higher
spending of $5,000 each year and the tax on profits is
30%, there will be a cash outflow of $5,000 but a cash
benefit from a reduction in tax payments of $1,500.
Slide 20
Example (Timing of cash flows for taxation)
• The after tax cost of capital is 8%. A project costing
$60,000 will be expected to earn cash profits of
$40,000 in year 1 and $50,000 in year 2.
• Taxation at 30% occurs one year in arrears of the
profits or losses to which they relate.
• For the purpose of this exercise, assume that the cost
of the project is not an allowable cost for tax
purposes(capital allowances should be ignored).
• Required: Calculate the NPV of the project.
Slide 21
Tax-allowable depreciation (capital allowances)
• When a business buys a non-current assets,
depreciation is charged in the financial accounts.
However, depreciation in the financial accounts is not
an allowable expense for tax purposes.
• The tax rules provide for ‘tax-allowable
depreciation’ or capital allowances, according to
rules determined by the government.
• Tax-allowable depreciation affects the cash flows from
an investment, and the tax effects must be included in
the project cash flows.
Slide 23
Tax-allowable depreciation (capital allowances)
There are two ways of allowing depreciation for
tax purposes:
• The straight-line method
• The reducing balance method
Slide 24
Example (straight-line method)
• An asset costs $80,000 and has an expected economic
life of four years with no residual value. If depreciation
is allowed for purposes over four years using the
straight-line method, the allowable depreciation would
be $20,000 each year.
• If the rate of tax on profits is 25%, the annual
reduction in tax from the capital allowance is $20,000
x 25% = 5,000 for four years.
Slide 25
Answer
Slide 26
Answer
The tax cash flows (tax savings) should e treated
as cash inflows in the appropriate year in the DCF
analysis. In this example:
• If tax cash flows occurs in the same year as that
the allowance is claimed, the cash inflows of
$5,000 will occurs in each of the years 1- 4.
• If tax cash flows occur in the year following the
claim for the allowance, the cash inflows of
$5,000 will occur in each of the years 2 – 5.
Slide 27
Example (Reducing balance method)
• An asset costs $80,000. Tax allowable
depreciation is 25% on a reducing balance basis.
Tax on profits is payable at the rate of 30%. The
cash flow benefits from the tax depreciation are
calculated as follows:
Slide 28
Answer
• Note: TWDV = the tax written-down value of the asset.
Slide 29
Balancing charge or balancing allowance on disposal
• Balancing allowance. If the written-down value of the asset for
tax purposes is higher than the disposal value, the difference is a
balancing allowance. The balancing allowance is set against
taxable profits, and so it will result in a reduction in tax
payments of:
Balancing allowance x Tax rate = Cash saving
• Balancing charge. If the written-down value of the asset for tax
purposes is lower than the disposal value, the difference is a
balancing charge. The balancing charge is a taxable amount, and
will result in an increase in tax payments of:
Balancing charge x Tax rate = Cash payment
Slide 30
Example
• A company is considering an investment in a non-
current asset costing $80,000. The project would
generate the following cash profits:
Year $
1 50,000
2 40,000
3 20,000
4 10,000
Slide 31
Example
• The asset is eligible for tax-allowable
depreciation at 25% by the reducing balance
method. It is expected to have a residual value
of $20,000 at the end of year 4, when it will be
disposed of. The after-tax cost of capital is 9%.
The rate of tax on profits is 30%. Taxation cash
flows occur one year in arrears.
• Required: Calculate the NPV of the project.
Slide 32
Chapter Roundup
• Inflation is a feature of all economies, and it must be
accommodated in financial planning.
• Real cash flows (ie adjusted for inflation) should be discounted
at a real discount rate.
• Nominal cash flows should be discounted at a nominal
discount rate.
• Taxation is a major practical consideration for businesses. It is
vital to take it into account in making decisions.
• In investment appraisal, tax is often assumed to be payable one
year in arrears. Tax-allowable depreciation details should be
checked in any question you attempt.
Slide 35