Investment Appraisal – Treatment of Advance Payments in the Tax Computations

Dear Mr John,

Trust you are keeping well.

In attempting ‘Test Your Understanding 6’ of the Kaplan Study Text, I observed that in using the pro-forma, I was right in my treatment of the advance payment of 3.8m Euros but my tax computation was incorrect. The solution showed that the advance payment was treated in the following year in the tax calculation workings.

Please can you explain why this was treated that way.

Apologies for sending this initially to the wrong forum and for assuming that you had the Kaplan text.

Below is a copy of the question. I’ll like to know the rational behind the tax computation solution.

Regards,

‘Wande.

Question:

“Puxty plc is a specialist manufacturer of window frames. Its main UK
manufacturing operation is based in the south of England, from where it distributes its products throughout the UK.

The directors are now considering whether they should open up an
additional manufacturing operation in France – which they believe there will be a good market for their products.

A suitable factory has been located just outside Paris that could be rented on a 5-year lease at an annual charge of €3.8m, payable each year in advance. The manufacturing equipment would cost €75m, of which €60m would have to be paid at the start of the project, with the balance payable 12 months later.

At the start of each year the French factory would require working capital equal to 40% of that year’s sales revenues. It is expected that the factory will be able to produce and sell 80,000 window units per year although, in the first year, because of the need to ‘run in’ the machinery and its new workforce, output is only expected to be 50,000 window units. Each window is likely to be sold for €750, a price that represents a 150% markup on cash production costs.

The French factory would be set up as a wholly-owned subsidiary of
Puxty plc. In France, 25% straight-line depreciation on cost is an
allowable expense against company tax. Corporation tax is payable at
40% at each year-end without delay and any unused losses can be
brought forward for set off against the following year’s profits. No UK tax would be payable on the after-tax French profits.

All amounts in € are given in current terms. Annual inflation in France is expected to run at 6% per year in the foreseeable future. All € cash flows involved are expected to increase in line with this inflation rate, with the exception of the factory rental and the cost of the manufacturing equipment, both of which would remain unchanged.

The French factory would be producing windows to a special design
patented by Puxty. To protect its patent rights, Puxty plc will charge its
French subsidiary a fixed royalty of £20 per window. This cost would be allowable against the subsidiary’s French tax liability.

The current €/£ spot rate is 1.5. Inflation in the UK is expected to be 4% per year over the period. There are no remittance restrictions between France and the UK.

Puxty plc is an all-equity financed company that is quoted on the London Stock Exchange. Its shares have a beta value of 1.25. The current annual return on UK Government Treasury Bills is 10% and the expected return on the market is 18%. In the UK Corporation Tax is payable at 35%, one year in arrears.

Puxty operates on a 5-year planning horizon. At the end of five years,
assume that working capital would be fully recovered and the production equipment would have a scrap value, at that time, of €70m before tax.

Proceeds on asset sales are taxed at 40%. Assume all cash flows arise at the end of the year to which they relate, unless otherwise stated.

Required:
Evaluate the proposed investment in France and recommend what
investment decision should be made by Puxty plc. State clearly any
assumptions you make and work all calculations rounded to nearest
10,000 (either € or £) – i.e. €0.01 m or £0.01m.