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Dear sir,
The following is an extract from a BPP study text question:
“The initial capital expenditure of an investment is $2m…its scrap value at the end of the 4-year project is $800k; tax payable at 35% one year in arrear; tax-allowable depreciation is at 25% straight-line basis, and can be claim one year after the investment ie at t1”
What the solution in the book does is that the company will claim $175k ($2m x 25% x 35%) annually from t1-t4 (a total of $700k), and a tax charge of $280k ($800k x 35%) on the “realisable value” at t5.
If I remember correctly (hopefully…), what we used to do (the tutorials in OT notes) for these tax-allowable depreciation is that we calculate the total tax-allowable figure beforehand ie (the cost – the scrap value) for this case it’s $2m – $800k = $1.2m, thus the straight-line dep’n amount from t1-t4 is $300k which ultimately resulting in the annual tax-saving amount to be $105 ($300 x 35%); (a total of $420k) throughout the 4 years.
As you can see sir, the tax-saving amount will be the same, but the timing and the exact figure will definately cause issue regarding the NPV calculation later on. Please advice me on what should be the more appropriate approach or if there is any specific reasons behind this two different approaches.
I hope I made myself clear enough with the question, hope to hear from you soon! ?
When calculating depreciation for tax purposes, it should always be calculated on the original cost (whether reducing balance or straight line). Obviously this may end up being different from the depreciation charge in the financial accounts, but that is not what we are after when setting up the cash flows.
(Having said that, when it was asked in the exam the examiner did not deduct marks if people had subtracted the estimated scrap proceeds when calculating the depreciation.)
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