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Dear Tutor(s),
I am having some problems with Investment Appraisal by NPV Analysis with taxation as below:
1. What exactly is the ‘post-tax’ discount rate? As I am understanding, if we use cost of capital as discount rate, ‘post-tax’ rate will be calculated = Cost of equity * %Equity + Interest * (1-Tax rate) *%Debt.
2. In the cash flows, why we only include the cash flow from tax saving of ‘tax allowable’ depreciation but NOT saving from ‘debt interest’?
3. Am I correct if I would include the tax saving not only of ‘tax allowable’ depreciation but also of any non-cash costs which are allowed in tax calculation.
For example: In a very simple project with 1 year life span, we invest $100 in inventories in Year 0, then in Year 1 sold them for $110 cash. Tax on Net operating cash flow = 110 x tax rate. Saving from cost of sale (which is non-cash expense in Year 1) = 100 x tax rate. So net tax outflow = 10 x tax rate.Tks you so much!
PS: Sorry so much, after posting I’ve found that I posted it wrongly to F8 not F9 Section!!!
Moderated: no problem at all it’s now in F9
SeagoatSorry if my questions seem to be basic and not smart but please anyone, tutor or some good fellows explain these problems for me! It has been several weeks and there is no reply at all!
You really need to watch all the lectures on NPV calculations and on cost of capital.
In answer to your first question: we discount at the cost of capital to the company. Because interest gets tax relief, the cost of debt is after the tax saving on interest. (It is as you have written if the debt is irredeemable, but gets a little bit more complicated to calculate when the debt is redeemable).
In answer to your second question, we are taking account of the cost of interest on debt, and the tax saving on it, when we calculate the cost of capital. To include either the interest or the tax saving on it in the cash flows would be accounting for it twice. We never include the interest on debt, or the tax saving on it, in the cash flows.
You would include any non-cash costs in calculating the tax, but the only one you will see is tax-allowable depreciation (or capital allowances). In your example, the cost of sale is not a non-cash expense at time 1. Buying the goods in the first place is a cash outflow and we record the cash outflow in whatever time period it occurs – we are not trying to produce profit statements, purely cash flow statements.
Again, you will find it helpful to watch all the free lectures.
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