F9 – FINANCIAL MANAGEMENT INVESTMENT APPRAISAL

ALLOWING FOR INFLATION, TAXATION AND WORKING CAPITAL IN DCF

Relationship between interest rates and inflation

This can be seen from Fisher formula which is given in exam, (1 + i) = (1 + r)(1 + h),
i = nominal or money rate of interest, r = real rate of interest, h = inflation rate. Real rate
of interest is the interest that is adjusted for inflation while nominal rate of interest
covers inflation as well. In this formula, we can seem that if inflation rises, the nominal
rate of interest will also rise and this can be taken as the discount factor to use.

You can assume that cash flows you are given in the exam are the money cash
flows unless told otherwise.

Inflate using general rate

Current cash flows Money cash flows
Deflate using general rate
Money cash flows Real cash flows

The rule to decide whether to use real rate or nominal rate in NPV computation is as
follow:
1. If cash flows are expressed in actual number of dollars that will be received or
paid on the various future dates, use nominal rate for discounting.
2. If cash flows are expressed in value of dollar at time 0 (i.e. current price level),
use real rate for discounting.
Nominal cash flows should be discounted at nominal rate while real cash flows
should be discounted at real rate of return.

Example:
Inflation rate is 10% a year and company requires a minimum return of 20% on the
project.
The cash flows of the project are as follow, calculate NPV.
Time Cash flows ($)
0 (15000)
1 9000
2 8000
3 7000

If the inflation rate of some cash flows is different than the general level of inflation, you
just need to inflate those cash flows specifically for each year and finally discount at
nominal rate.
Note that you should not inflate those cash flows which are affected by general level of
inflation as the nominal rate has taken into account about it.
Practice 1.
Shadow line Co has a money cost of capital of 10%. If inflation is 4%, what is Shadow
line Co.’s real cost of capital (to one decimal place)?

INFLATION, TAXATION & WORKING CAPITAL M. SOHAIL ANJUM (ACCA, APFA)

 F9 – FINANCIAL MANAGEMENT INVESTMENT APPRAISAL

Practice Question 2.
Which of the following is true about the 'inflation' figure that is included in the money
cost of capital?
A. It is historic and specific to the business
B. It is historic general inflation suffered by the investors
C. It is expected and specific to the business
D. It is expected general inflation suffered by the investors

Taxation effects of relevant cash flows:

In investment appraisal, tax is often assumed to be payable one year in arrears (this
year tax is paid next year)

. IMPACT OF CORPORATION
TAX

TAX RELIEF ON INVESTMENT

TAX CHARGED ON OPERRATIVE
SPENDING
FLOWS

ADDITIONAL INOCOME = TAX ALLOWABLE DEPRECIATION

ADDITIONAL TAX IS ALLOWED AS AN EXPENSE
ADDITIONAL COST = TAX SAVINGS AGAINST PROFITS INSTEAD OF
DEPRECIATION

EFFECT OF TAXATION ON CASH FLOWS DUE TO PROFIT/LOSS:

Project cash flows will give rise to taxation which itself has an impact on the project
appraisal. Normally we assume that tax paid on operating flows is due one year after
the related cash flow.
However, it is possible for alternative assumptions to be made and so you should read
any examination question carefully to ascertain precisely what assumptions are made in
the question.

EFFECT OF TAXATION IN THE FORM OF CAPITAL ALLOWANCES:

You have learnt in taxation that capital allowance (tax-allowable depreciation/writing
down allowance) can reduce the amount of tax payable, the tax benefit of the capital
allowance is a relevant cash flow (not the tax-allowable depreciation!). This tax savings
can be calculated by capital allowance x tax rate. You also know that when you sell an
asset, there is either balancing charge (sale price > tax written down value, this will be
taxable profit) or balancing allowance (tax written down value > sale price, this will be
tax allowable loss), again the tax effect (e.g. taxable profit x tax rate) on the sale of

INFLATION, TAXATION & WORKING CAPITAL M. SOHAIL ANJUM (ACCA, APFA)

F9 – FINANCIAL MANAGEMENT INVESTMENT APPRAISAL

asset is a relevant cash flow. In the year of disposal, capital allowance cannot be
claimed. If you have some cost savings, this will subject to extra tax payable.

Example: Psychic Co is considering whether or not to purchase an item of machinery

costing $40000 payable immediately. It would have a life of 4 years, after which it would
be sold for $5000. The machinery would create annual cost savings of $14000.
The company pays tax one year in arrears at an annual rate of 30% and can claim
capital allowance on a 25% reducing balance basis. A balancing allowance is claimed in
the final year of operation. The company’s cost of capital is 8%. Should the machinery
be purchased?

Working capital
This is relatively simple. Increases in working capital would mean more investment in
working capital, so there will be a cash outflow. Remember, only the changes in working
capital investment are cash flows. Working capital is assumed to be recovered at the
end of the project.

Example: A project lasts for 5 years with a $20000 working capital requirement at the
end of year 1, rising to $30000 at the end of year 2. State the effect of this.

INFLATION, TAXATION & WORKING CAPITAL M. SOHAIL ANJUM (ACCA, APFA)

F9 – FINANCIAL MANAGEMENT INVESTMENT APPRAISAL

PRACTICE QUESTIONS:
1. SW Co has a 31 December year end and pays corporation tax at a rate of 30%, 12
months after the end of the year to which the cash flows relate. It can claim tax-allowable
depreciation at a rate of 25% reducing balance. It pays $1m for a machine on 31 December
20X4. SW Co.’s cost of capital is 10%.
What is the present value on 31 December 20X4 of the benefit of the first portion of tax
allowable depreciation?
A. $250,000
B. $227,250
C. $68,175
D. $75,000
2. A company receives a perpetuity of $20,000 per year in arrears, and pays 30%
corporation tax 12 months after the end of the year to which the cash flows relate.
At a cost of capital of 10%, what is the after-tax present value of the perpetuity?
A. $140,000
B. $145,454
C. $144,000
D. $127,274
3. AW Co needs to have $100,000 working capital in place immediately for the start of a
2- year project. The amount will stay constant in real terms. Inflation is running at 10% per
year, and AW Co's money cost of capital is 12%.
What is the present value of the cash flows relating to working capital?
A. $(21,260)
B. $(20,300)
C. $(108,730)
D. $(4,090)
4. NCW Co is considering investing $10,000 immediately in a 1-year project with the
following cash flows.
Income $100,000
Expenses $35,000
The cash flows will arise at the end of the year. The above are stated in current terms.
Income is subject to 10% inflation; expenses will not vary. The real cost of capital is 8% and
general inflation is 2%.
Using the money cost of capital to the nearest whole percentage, what is the NET present
value of the project?
A. $68,175
B. $60,190
C. $58,175
D. $78,175
5. AM Co will receive a perpetuity starting in 2 years' time of $10,000 per year,
increasing by the rate of inflation (which is 2%).
What is the present value of this perpetuity assuming a money cost of capital of 10.2%?
A. $90,910
B. $125,000
C. $115,740
D. $74,403

INFLATION, TAXATION & WORKING CAPITAL M. SOHAIL ANJUM (ACCA, APFA)

F9 – FINANCIAL MANAGEMENT INVESTMENT APPRAISAL

6. FW Co is expecting a receipt of $10,000 (in real terms) in 1 years’ time.

If FW Co expects inflation to increase, and receipts are expected to rise in line with the general
rate of inflation, what impact will this have on the present value of that receipt?
A. Nil
B. Reduce
C. Increase
D. Cannot say
7. Shadow line Co has a money cost of capital of 10%. If inflation is 4%, what is Shadow
line Co.’s real cost of capital (to one decimal place)?

8. Juicy Co is considering investing in a new industrial juicer for use on a new contract.
It will cost $150,000 and will last 2 years. Juicy Co pays corporation tax at 30% (as the cash
flows occur) and, due to the health benefits of juicing, the machine attracts 100% tax
allowable depreciation immediately.
Given a cost of capital of 10%, what is the minimum value of the pre-tax contract revenue
receivable in two years which would be required to recover the net cost of the juicer?
A. $150,000
B. $105,000
C. $127,050
D. $181,500
9. Which of the following is true about the 'inflation' figure that is included in the money
cost of capital?
A. It is historic and specific to the business
B. It is historic general inflation suffered by the investors
C. It is expected and specific to the business
D. It is expected general inflation suffered by the investors
SECTION B TYPE QUESTIONS:

Trecor Co
The following scenario relates to questions 145–149.
Trecor Co plans to buy a machine costing $250,000 which will last for 4 years and then be sold
for $5,000.
Net cash flows before tax are expected to be as follows.
T1 T2 T3 T4
Net cash flow $ 122,000 143,000 187,000 78,000
Depreciation is charged on a straight-line basis over the life of an asset.

1. Calculate the before-tax return on capital employed (accounting rate of return) based on the
average investment (to the nearest whole percentage).

2. Are the following statements on return on capital employed (ROCE) true or false?

True False

INFLATION, TAXATION & WORKING CAPITAL M. SOHAIL ANJUM (ACCA, APFA)

F9 – FINANCIAL MANAGEMENT INVESTMENT APPRAISAL

1 If ROCE is less than the target ROCE then the purchase of the machine can be
recommended.

2 ROCE can be used to compare two mutually exclusive projects.

3. Trecor Co can claim tax-allowable depreciation on a 25% reducing balance basis. It
pays tax at an annual rate of 30% one year in arrears.
What amount of tax relief would be received by Trecor in time 4 of a net present value (NPV)
calculation? $

4. What is the payback period for the machine (to the nearest whole month)?
Years Months
5. Which TWO of the following statements about the internal rate of return (IRR) are
TRUE?
􀂅 IRR ignores the relative sizes of investments.
􀂅 IRR measures the increase in company value.
􀂅 IRR can incorporate discount rate changes during the life of the project.
􀂅 IRR and NPV sometimes give conflicting rankings over which project should be prioritised.

BRT Co
The following scenario relates to questions 150–154.
BRT Co has developed a new confectionery line that can be sold for $5.00 per box and that is
expected to have continuing popularity for many years. The finance director has proposed that
investment in the new product should be evaluated over a four-year time-horizon, even though
sales would continue after the fourth year, on the grounds that cash flows after four years are
too uncertain to be included.
The variable cost (in current price terms) will depend on sales volume, as follows.
Sales volume (boxes) Less than 1 million 1–1.9 million 2–2.9 million 3–3.9 million
Variable cost ($ per box) 2.80 3.00 3.00 3.05
Forecast sales volumes are as follows.
Year 1 2 3 4
Demand (boxes) 0.7 million 1.6 million 2.1 million 3.0 million

Tax
Tax-allowable depreciation on a 25% reducing balance basis could be claimed on the cost of
equipment. Profit tax of 30% per year will be payable one year in arrears. A balancing allowance
would be claimed in the fourth year of operation.

Inflation
The average general level of inflation is expected to be 3% per year for the selling price and
variable costs. BRT Co uses a nominal after-tax cost of capital of 12% to appraise new
investment projects.
A trainee accountant at BRT Co has started a spreadsheet to calculate the net present value
(NPV) of a proposed new project.

INFLATION, TAXATION & WORKING CAPITAL M. SOHAIL ANJUM (ACCA, APFA)

F9 – FINANCIAL MANAGEMENT INVESTMENT APPRAISAL

What is the sales figure for Year 2 (cell D3 in the spreadsheet), to the nearest $'000?

What are the variable costs for Year 3 (cell E4 in the spreadsheet), to the nearest $'000?

What are the tax benefits generated by the tax-allowable depreciation on the equipment
in Year 4 (cell F8), to the nearest $'000?

Which of the following statements about the project appraisal are true/false?
True False
1 The trainee accountant has used the wrong percentage for the cost of capital.
2 Ignoring sales after four years underestimates the value of the project.
3 The working capital figure in Year 4 is wrong.
The trainee accountant at BRT Co has calculated the internal rate of return (IRR) for the
project.
Are the following statements true or false?
1 When cash flow patterns are conventional, the NPV and IRR methods will give the same
accept or reject decision.
2 The project is financially viable under IRR if it exceeds the cost of capital.
􀂅 Both statements are true
􀂅 Both statements are false
􀂅 Statement 1 is true and statement 2 is false
􀂅 Statement 2 is true and statement 1 is false

INFLATION, TAXATION & WORKING CAPITAL M. SOHAIL ANJUM (ACCA, APFA)

F9 – FINANCIAL MANAGEMENT INVESTMENT APPRAISAL

SECTION C TYPE PRACTICE QUESTION

Project E
Project E is a strategically important project which the board of OAP Co has decided must be
undertaken in order for the company to remain competitive, regardless of its financial
acceptability. The project has a life of four years. Information relating to the future cash flows of
this project are as follows:
Year 1 2 3 4
Sales volume (units) 12,000 13,000 10,000 10,000
Selling price ($/unit) 450 475 500 570
Variable cost ($/unit) 260 280 295 320
Fixed costs ($'000) 750 750 750 750

These forecasts are before taking into account of selling price inflation of 5.0% per year,
variable cost inflation of 6.0% per year and fixed cost inflation of 3.5% per year. The fixed costs
are incremental fixed costs which are associated with Project E. At the end of 4 years,
machinery from the project will be sold for scrap with a value of $400,000. Tax-allowable
depreciation on the initial investment cost of Project E is available on a 25% reducing balance
basis and OAP Co pays corporation tax of 28% per year, one year in arrears. A balancing
charge or allowance is available at the end of the fourth year of operation.

OAP Co has a nominal after-tax cost of capital of 13% per year. The initial investment for
Project E is $5,000,000.

Required
Calculate the nominal after-tax net present value of Project E and comment on the
financial acceptability of this project.

INFLATION, TAXATION & WORKING CAPITAL M. SOHAIL ANJUM (ACCA, APFA)