F9 Financial Management

2 Section D: Investment appraisal Designed to give you the knowledge and application of: D3. Discounted cash flow (DCF) techniques D4. Allowing for inflation and taxation in DCF

3 Learning Outcomes Allowing for inflation and taxation in DCF  Discuss the real-terms and nominal terms approaches to investment appraisal. [2]  Calculate the taxation effects of the relevant cash flows [2]  Calculate and apply before- and after-tax discount rates. [2]

4 The real-terms and nominal terms approaches to investment appraisal Real vs. Nominal cash flows Real cash flows are cash flows that have not been subjected to inflation Nominal cash flows or money cash flows have been influenced by inflation (1+ Nominal rate or money rate) = (1+ Real rate) x (1+ Inflation rate) Discounted using the real cost of capital Discounted using the nominal cost of capital Continued …

5 Example If Steve’s real rate of return required is 10% and inflation 6% the effective nominal rate will be: (1+ Nominal rate or money rate) = (1+ Real rate) x (1+ Inflation rate) = ( ) x ( ) – 1 = 1.10 x 1.06 = = = 16.6% Continued …

6 apply the nominal rate to discount each cash flow & hence calculate NPV discount each cash flow according to the applicable rate of inflation When different costs & benefits are subject to different inflation rates When inflation rate changes during the life of a project

7 Taxation effects of the relevant cash flows Example Belco Ltd currently pays corporation tax at a rate of 28%. It is considering investing in a new production line which it expects will generate additional sales revenue of $200,000 per annum. Belco Ltd realises that it will also incur additional operating expenses of $40,000 per annum. This will lower the company’s overall profit thereby reducing the amount of tax to be paid. The adjusted cash outflow on account of taxation would be $44,800 i.e. (200,000 - $40,000) x 28%. increase profits, resulting in tax increases shown as cash outflows reduce profits, resulting in tax savings shown as cash inflows Revenues (inflows) Expenses (outflows) Refers to revenue expenditure or income affecting operating profit

8 loss on disposal tax relief on disposal profit on disposal tax payment after tax cost of capital is used for calculation allowable against profits resulting in tax savings shown as cash inflows Balancing allowance / charge Capital allowances Disposal of assetsInterest payments Capital Cash Flow

9 $ Initial cost of assetX Cumulative capital allowances claimed(X) Written down value of assetX Disposal proceeds(X) Balancing (allowance)/chargeX Tax saved / paidX Calculation of balancing allowance / charge Accounting policies and standards of each country Local tax policies Interest payment to discount the project cash flows Timing of taxation items i.e., period on which they are taxes Continued …

10 Example Realson estimated that a project will give net cash inflows of $100,000 during year 1, and $150,000 during year 2. Corporate tax rate is 28%. What are the tax cash flows to be planned year-wise? Assuming that the taxable profits are the same as cash inflows and there is a lag of one year in the tax payments, the tax out flows will be as follows: Cash inflow year Cash inflow amount Tax outflow year Cash (tax) outflow amount 28% 1100,000228, ,000342,000 Continued …

11 Application of tax rate for cash flow If cash flow is before tax After tax discount rate is to be applied If cash flow is after tax Before tax discount rate is to be applied As interest and tax effect needs to be eliminated from gross amount As discount needs to be eliminated to get present value gross amount After-tax rate = Before-tax rate x (1 – Tax rate) Refer to Self Examination Question 2 (page 208) Before & After tax rate for cash flow

12 Recap  Discuss the real-terms and nominal terms approaches to investment appraisal. [2]  Calculate the taxation effects of the relevant cash flows [2]  Calculate and apply before- and after-tax discount rates. [2]