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Hi Sir,
Would you please help me on the following.
A project is expected to generate pre-tax income of $90,000 per annum, starting in one year
and running in perpetuity. Tax is payable 12 months in arrears at 20%. The after tax cost of
capital is 8%.
What is the PV of the project flows?The solution is 917,000 but I am not clear on how to get to this result.
Thank you
Leo
The PV of the pre-tax inflows is 90,000 / 0.08 = 1,125,000.
The PV of the tax outflow on these flows is 20% x 1,125,000 x 1/1.08 (to discount for one extra tear because of the tax delay) = 208,333
Therefore the PV of the net flows is 1,125,000 – 208,333 = 916,667
Thank you for this. One more thing please I am not entirely clear.
It seems when we discount for one year we divide by 0.08. Instead when we discount for one extra year we divede by 1.08. If we were to discount for two extra years (instead of one) would we divide by (1.08)*(1.08)?Thank you
We divide by 0.08 because it is a perpetuity and the discount factor for a perpetuity is 1/r.
The tax flows are a perpetuity as well but they start 1 year later and to we divide by 1/1.08 to discount for one extra year. If the tax flows started 2 years later the we would divide by
(1/1.08)^2 to discount for two extra years (although it would be quicker to use the tables provided).I do suggest that you watch my free Paper MA lectures on Chapter 25 of the Paper MA lecture notes in addition to watching my free Paper FM lectures, because this is very basic discounting.
Hello John, Leo,
I’m having trouble understanding why do we use the post-tax discount rate of 8% to calculate the PV of pre-tax inflows of 90 000. Isn’t a rule to use the pre-tax discount rate for a pre-tax inflows?
Always use an after-tax rate for investment appraisal
or
Always use the after-tax WACC when appraising investments
or
Use a post-tax money discount rateIt’s in our excellent video, notes and in your textbook
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