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Hello sir
First I would like to thank you for guiding me to the appropriate forum.The company uses its after-tax weighted average cost of capital of 8% when appraising investment projects. The annual tax rate is 30%, and it is paid one year in arrears.
Project B
The initial investment of this project is $1.5m in addition to the $130,000 in working capital, which would be recovered fully in the final year of operation. An existing machine with a book value of $190,000 is to be used in this project. The expected life of this project is five years and there is no scrap value at the end. The machines used in this project are to be depreciated using straight line method.
The sales revenue to be generated by this project at the end of the first year would be $1m and it is expected to be increased by $300,000 every year. The total costs related to this project are expected to be increased by $240,000 every year from $630,000 in the first year.Above is the information regarding project B. There are other projects in which the tax allowable depreciation percentage is given but none is mentioned in this one. But since the company uses after tax cost of capital and corporation tax rate is given do we consider the tax benefit in this project like other projects of this company?
And regarding depreciation since it is not a relavent cashflow should it be added back to the net cashflow of this project when calculating npv? I asked this because some questions of this type are done that way. In this project also it is given the total revenue and the total costs per year. Should I assume that total costs given includes depreciation or not?This cannot have been an actual exam question because always in the exam (when there is tax (which there usually is)) you are told what the tax allowable depreciation (capital allowances) is.
Here, you really have no choice but to assume that the tax allowable depreciation is simply the straight-line accounting depreciation.
Depreciation itself is never relevant on its own because it is not a cash flow. It is only relevant for calculating the tax.
You really need to watch the free lecture on investment appraisal with tax – I cannot type out the whole lecture here.
Basically, then best way of dealing with it is to calculate the tax on the profits before depreciation, and then to calculate separately the tax saving on the depreciation.(The alternative, which gives the same result) is to separately do a little tax calculation based on the profit after depreciation. Then show the tax payables as a cash outflow. But not showing ever the depreciation itself as a cash flow.)
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