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An asset costing $40,000 is expected to last for three years, after which is can be sold for $16,000. The corporation tax rate is 30%, tax-allowable depreciation at 25% is available, and the cost of capital is 10%. Tax is payable at the end of each financial year. Capital expenditure occurs on the last day of a financial year, and the tax-allowable depreciation is claimed as early as possible. What is the cash flow in respect of tax-allowable depreciation that will be used at time 2 of the net present value calculation?
Doubt in Solution to this question and the understanding of the line-
“Capital expenditure occurs on last day and tax allowable depn is claimed as early as possible”The TAD is always calculated on the last day of the accounting period.
If the purchase is on the last day of an accounting period, then this is time 0 and so the first TAD will be calculated on time 0. If the tax is payable at the end of each financial year (i.e. no delay in the payment of tax) then the first tax saving on TAD will be at time 0.
(More usually in the exam, the purchase is on the first day of an accounting period, which is time 0, and therefore the first TAD is calculated at the end of the accounting period which is time 1. Also, more usually in the exam, tax is payable one year after the end of the accounting period and therefore the first tax saving would be at. time 2).
I do explain how this all works in my free lectures on investment appraisal with tax.
If lease rentals are payable in advance for 3 years at T0, T1 and T2 ; and tax is payable in one year arrears,
In which year the tax savings on lease rentals appear and why ?In the book it is in T2,T3 and T4 which at first glance looks like a two year arrear
Is the reason same as TAD which you just mentioned , i.e. tax savings on lease payments will be calculated at the end of T0 which means it will be occur at the end of T1 (one year arrear) which is T2 starting?
There is no ‘end of T0’.
Time 0, time 1, time 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 the end of the second year/start of the third year
and so on.If the first lease payment is in advance then it is payable at the start of the first year, which is time 0.
There is no TAD (TAD only applies when an asset is purchased), but the lease payment is tax allowable and will reduce profits for the first year which are calculated at the end of the year which is time 1. If tax is payable 1 year in arrears, then the tax saving resulting at time 1 is actually saved one year later which is time 2.Again all of this is explained in my free lectures on investment appraisal with tax, and on lease and buy. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well. Please watch them, because you cannot expect me to type out my lectures again here 🙂
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