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Dear John, I am very confused about the timing of tax benefit, now I got a question would you please help me out? why they put the first tax depreciation in the year 2?
ASOP Co is considering an investment in new technology that will reduce operating costs through increasing energy efficiency and decreasing pollution. The new technology will $1m and have a four-year life, at the end of which it will have a scrap value of $100,000.
A licence fee of $ 104,000 is payable at the end of the first year. This licence fee will increase by 4% per year in each subsequent year.
The new technology is expected to reduce operating costs by $ 5.8 per unit in current terms. This reduction in operating costs is before taking account of expected inflation of 5% per year.
If ASOP Co bought the new technology, it would finance the purchase through a four-year loan paying interest at an annual before-tax of 8.6% per year.
If ASOP Co buys the new technology it can claim tax allowance depreciation on the investment on a 25% reducing balance basis. The company pays taxation one year in arrears at an annual rate of 30%. ASOP Co has an after-tax weighted average cost of capital of 11% per year. ($000)
The answer is that shown as follows:
…………,,………………………………….. Year0….year1…..year2…..year3….year4….year5
Capital costs………………………………(1000)
Licence fee……………………………………………..(104)…..(108)…..(112)…..(116)
Disposal proceeds………………………………………………………………………..100
Tax deduction @30%……………………………………………..31……..32……….34……..35
Tax allowable depreciation………………………………………75……. 56……….42……..96
Net cash flows……………………………(1000),,,,(104)……..(2)…….(24)………60……131
Discount at 6%…………………………. 1.000……0.943…..0.890….0.840…0.792…0.747
Pv of cash flows………………………..(1000)…….(98)……..(2)……..(20)……. 48…….980, 1, 2 etc are points in time that are 1 year apart.
Time 0 is the start of the first year.
Time 1 is the end of the first year / start of the second year
Time 2 is end of the second year / start of the third year
and so on.If a machine is bought at time 0, then the capital allowances are calculated at the end of the year, which is time 1.
Since tax is one year in arrears, the tax effect will be one year later which is time 2.I do suggest that you watch my free lectures on investment appraisal with tax, where I explain this in detail.
(Our free lectures are a complete course for Paper F9 and cover everything needed to be able to pass the exam well.)
thank you for your response, but in December 2002 Leaminger Co, it seems to be another story, shown as follows:
Leaminger Co has decided it must replace its major turbine machine on 31 December 2002. the machine is essential to operations of the company.
the machine is expected to cost $ 360,000 if it is purchased outright, payable on 31 December 2002, after four year the company expects new technology to make the machine redundant and it will be sold on 31 December 2006 generating proceeds of $20,000. tax allowable depreciation is available on the cost of the machine at the rate of 25% per annum reducing balance. A full year’s allowance is given in the year of acquisition but no tax allowance depreciation is available in the year of disposal. the difference between the proceeds and the tax written down value in the year of disposal is allowable or chargeable for tax as appropriate. Assume that tax is payable on year after the end of the accounting year in which the transaction occurs, the company ‘s accounting year-end is 31 December.
the answer is like that:
……………………………2002………….2003…………….2004………2005……….2006……..2007
purchase…………..(360,000)
tax allowable Dep……………………27,000………….20,250……15,188……11,391…..28,172Exactly! You really should watch the free lectures on on investment appraisal with tax and on lease and buy where again all this is explained in full!
It is because the machine is bought at the end of an accounting period.
So if 31 December 2002 is time 0, capital allowances are always calculated at the end of the accounting period and so they will be calculated on 31 December 2002 – time 0. There is a 1 year tax delay and therefore the tax effect will be 1 year later, which is time 1.Please watch the lectures – they are a complete course for F9, and I cannot type them all out here 🙂
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