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A company has 31 December as its accounting year end. On 1 January 20X5, a new machine costing $2,000,000 is purchased. The company expects to sell the machine on 31 December 20X6 for $350,000.
The rate of corporation tax for the company is 30% and tax is paid at the end of the year in which it is incurred. Tax-allowable depreciation is obtained at 25% on the reducing balance basis, and a balancing allowance is available on disposal of the asset. The company makes sufficient profits to obtain relief for tax-allowable depreciation as soon as they arise.
If the company’s cost of capital is 15% per annum, what is the present value of the tax savings from the tax allowable depreciation at 1 January, 20×5 (to the nearest thousand dollars)?
I just wanted to confirm two things in this question. Since machine was purchased on 1 Jan 20×5, should i take this cashflow to be shown in year 0 as it happened at the start of year 1? (not really required for this question, I am only asking for my own understanding).
If I show it to be in year 0, then only I can discount the tax saving at 31 dec 20×5 using year 1’s discount factor (because no discounting in year 0). Can you let me know if my concept is correct?
And also, I am a bit confused shouldn’t we use the post tax cost of capital for discounting?? I don’t understand when do we use it and when do we not use it?
Please let me know. Thanks in advance!
Since the machine is purchased on 1 January 20X5, it is indeed considered as occurring at the start of the accounting year, which is typically referred to as time 0.
Therefore, you can treat the cash flow related to the purchase as occurring at time 0. The tax savings from the tax-allowable depreciation will be realized at the end of the accounting period, which is 31 December 20X5 (time 1). You would then discount the tax savings using the discount factor for year 1, as there is no discounting for cash flows occurring at time 0.
Regarding the cost of capital, you generally use the post-tax cost of capital for discounting cash flows that are after tax. In this case, since the tax savings are a cash inflow that will be realised after tax, you should use the post-tax cost of capital for discounting.
The distinction is important because it ensures that the cash flows are evaluated on a consistent basis, reflecting the actual cash available to the company after accounting for taxes.
Thank you for your detailed response! I just checked in Kaplan, they have used the cost of capital, not adjusted it as ‘after tax cost of capital’, whereas there is a similar question that has used the after tax cost of capital. I don’t understand why the difference?
The difference in the use of cost of capital versus after-tax cost of capital often depends on the specific instructions given in the question.
Generally, when appraising projects, we always use the after-tax cost of capital to discount investments, as this reflects the tax savings on debt interest. However, if a question explicitly states to ignore tax, then the before-tax cost of capital may be used. It’s essential to carefully read the question to determine which cost of capital is appropriate for that specific scenario.It would make very little difference to your exam marks if you choose the wrong discount rate!
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