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Hi Tutor,
I came across a question in Kaplan’s exam kit relating to foreign investment appraisal + risk adjusted PV, “Tramount Co (PILOT 12)” and I don’t quite agree with the answer to the additional tax, but have to make sure I’m corrected if I’m wrong just in case if a similar question comes up in the coming exam.
In summary, Tramont Co (a company in the US) is assessing whether to cease one of its productions in the US and relocates to another country, Gamala. US tax rate is 30% and Gamala tax rate is 20%, so there will be an additional 10% on the taxable profit payable in the US.
Personally, I think this 10% should be included in the “Base case NPV” because: (1) The overall tax rate is still 30% regardless to where the production is based between these two countries, or how the project is financed (i.e. all-equity, all-debt, or equity-debt mix); (2) Base case NPV is assumed to be all equity-financed but it does not affect the country tax rates – the 10% is still payable regardless of how the capital is structured. Base case NPV is correctly discounted at 16% (all equity-financed).
However, the answer treated this 10% tax as part of the “risk adjusted workings” as an additional tax as if it arises due to the financing impact/effect, and clearly it is not because both are the country’s tax rate, which has nothing to do and will not be affected by method of financing. In the answer, it is calculated together with the opportunity cost and additional contribution and discounted at 7% (the cost of capital in the US provided in the question).
If this 10% tax effect is not included in the “Base case NPV”, then the base case NPV value is missing the value of the additional tax payable in the US, therefore, it does not reflect the PV of the NET cash inflow. Note that the answers will differ because of the different discount rates (16% vs. 7%).
It may be that, in other case scenario, the NPV may turn to negative value just because this issue, therefore, I must ensure I fully understand this area. Please kindly assist to correct me if I’m wrong.
Looking forward for your reply and thanks in advance!
Reference (please refer to question 1):
Best regards,
KennyYou must not put links to that website on our website because past exams are copyright of the ACCA and the website you link to is hosting the questions and answers illegally.
The answer is the examiners own answer, and is because the question specifically asks for the flows from the project to be discounted at the all-equity rate and then adjusted for all other relevant cash flows. The extra tax is not a direct cash flow of the project itself, even though it occurs because of it. It is an extra cash flow that occurs in the USA (which is where the extra tax is payable) and the question specifically says that all cash flows in the USA should be discounted at 7%.
Hi John,
Sorry for the link, I will make sure I won’t in the future.
Thanks for the clarification, clear now.
Best regards,
Kenny
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