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Juicy Co is considering investing in a new industrial juicer for use on a new contract. It will cost $150,000
and will last 2 years. Juicy Co pays corporation tax at 30% (as the cash flows occur) and, due to the health
benefits of juicing, the machine attracts 100% tax-allowable depreciation immediately.
Given a cost of capital of 10%, what is the minimum value of the pre-tax contract revenue receivable in two
years which would be required to recover the net cost of the juicer?
Hi sir, could you please explain this question?
The minimum value of the receipt in 2 years time is whatever will end up making the NPV of the investment equal to zero.
So let the pre-tax revenue at time 2 be X. Calculate the NPV of all the flows (in terms of X) and then use simple algebra to find out what value of X makes the NPV equal to zero.
Okay so I understand the rest but I’m confused how the tax allowable depreciation is reducing the cost of the investment in this question. I mean they act as tax savings so they will reduce the tax but why do we remove the whole 45000 from the investment?
The tax allowable depreciation is 100% x $150,000.
This means that the taxable profit is reduced by $150,000 and they will save tax of 30% x $150,000 = $45,000.
Paying less tax of $45,000 is a saving and therefore effectively an inflow.
Have you watched my free lectures on investment appraisal with tax?
Yes sir I have. I meant wouldn’t they first act as a tax saving and when they fully cover the tax expense THEN reduce the cost of the investment?
They never reduce the cost of the investment.
Tax allowable depreciation reduces the taxable profit and therefore saves tax.
We always assume that the company is already making lots of profit and is therefore paying lots of tax. So the the capital allowances on the new investment will reduce the existing profit of the company, therefore mean less tax payable, and therefore result in a tax saving.