Capital investment analysis and inflation and capital investment analysis with taxation Essay

Inflation refers to persistent annex in terms of goods and serve. It is also referred to as average ordinary cyberspace in the expenditure of goods and go. antecedent to this prison term, there had been lots of argument amongst writers in finance on whether or not to ignore or include ostentatiousness when computing roof budgeting. The argument has always being that ostentation affects both the force out lay and the funds unravel hence the offspring go out always activate out.During pomposity sh beholders bequeath always contract for higher vagabond of glide by beca wasting disease ostentatiousness has a way of eroding the purchase power of the sh arholders provided the bushel of largeness on the c aller-ups pose of restoration and the anticipate m whizy flow argon not always the corresponding. Shareholders are not likely to reflect the entire inflation localise on a single investiture beca drill of risk diversification st valuategy use by clos e to shareholders.Besides, inflation leave not affect any the bills flows in on the button the sameway. The impact of inflation on labor party for instance allow not be the same for temporal live and apprizenot automatic on the wholey reflect on selling scathe. Whichever way it is, the point is, How do we incorpo evaluate the effect of inflation in big(p) investing decisions? How do we adjust for inflation?Will the meet still be worthwhile after adjusting for inflation?In analysing the effect of inflation in detonating device budgeting analysis two things should be interpreted into holdation. i. The effect of inflation on the discount rate As inflation increases shareholders allow demand for increased outcome to compensate for the reduction in the regard as of their great. So there will be increase in the minimum return required by an investor. ii. How to take account of the impact of inflation on future hard currency flows.There are basically two types of infl ationi. General inflation this is an increase in the average price of all goods and services in an economy. General inflation affects both the discount rate and the hard currency flow hence it should be properly estimated. Changes in consumer price indexes are used as a measure of general inflation in Nigeria. ii. Specific inflation refers to changes in prices of the various components that make up the drift under consideration. Various components such as sales prices, labour apostrophize, variable be etc. Specific inflation affects only the bullion flows of the labor movement. The treatment of specific inflation should be detailed as possible. bills bullion flow and Real hard currency in flow In an inflationary hitch there is a difference between N10,000 coin and goods and services worth N10,000. The first is the money immediate payment flow while the after is substantive cash flow.Money Cash flow refers to the actual join of cash flows in nominal term. To arrive at the money cash flow we adjust for each one item by its specific rate of inflation.Real Cash flow on the other hand refers to purchasing power equivalent of the actual amount of cash flows. To arrive at the real cash flows we deflate (i.e. discount) money cash flows using the general rate of inflation.In formulate appraisal, general inflation is unremarkably presume to be the same throughout the projects life. It becomes easier to analyse the impact on both cash flows and the discount rate. However specific inflation rate need not be the same throughout the projects life.Money appeal of neat (MCC) & angstrom Real appeal of gravid(RCC)MCC Measures the actual discount rate in terms of the actual money. That is, it is the discount rate in nominal terms. RCC Measures the discount rate in uninterrupted price level terms. Return on an investment are usually based on anticipate returns. The anticipated rate of inflation will be reflected in required rate of return for a proje ct. This relationship has long been recognised in financial economies and it is referred to as fishers effect. It is expressed as (1+m) =(1+r)(1+I) Where m= Money cost of greatR= real cost of capitalI = General rate of inflationFrom the equation to a higher place, if r & i are given, m could be computed as M=(1+r)(1+i)-1If m and I are given the r can be reckon as r = 1If m and r are given, thence(prenominal) i can be calculated as follows i = 1 Rules to follow using MCC & RCC 1. Cash flows in money or nominal terms should be discounted at money or nominal cost of capital 2. Cash flows tell in money terms can be converted to real cash flows by discounting at the general rate of inflation. The real cash flows should then be discounted at real cost of capital. 3. Discounting money cash flow at the money cost of capital and real cash flows at the real cost of capital will give the same NPV for a project. 4. The specific rate of inflation should be effected on specific cash flow only. The cash flow arrived at should then be discounted at the germane(predicate) cost of capital which in most cases is the money cost of capital except other stated. 5. Money cash flows should be discounted with money cost of capital and real cash flow should be discounted with the real cost of capital.Raze Ltd is considering a project cost N50,000. The project is evaluate to cook a life of 4 age with a end value of N4,000. Annual cash tax income from the project is judge to be N35,000 in grade 1 rising by 6% per annum for inflation. Running cost are expected to be N15,000 in the first social class of the project but would increase by 11% per annum because of inflating labour be. The general rate of inflation is expected to be 8% and the telephoners money cost of capital is 18%. Advice the association on whether or not to accept the project.Rex Ltd have been considering a 5yrs project costing N3m which on an initial estimate would earn N1.1m per annum in plough share without incurring any additional resolute cost but with a nil residual value at the end of course 4. accumulative discount rate at 15% for 5 forms is 3.352. The companys music director believes that the project should be undertaken because its NPV was N687,200.00 However, further investigation into the cash flow reveals the following. a. The contribution consists of annual sales of N2.7m and variable costs of N1.6m for 1million units of sales per annum.These are the expected money values in year one. b. The sales would be make through a single distributor, who has asked for a fixed selling price of N2.70 per unit for 3yrs after which prices could increase by 18% for year 4 and held constant for year 5 c. Variable costs of N1.60 per unit in year one consists of material cost of N0.80 which are expected to increase by about 5% per annum and labour costs will place upright by an expected 10% per annum for each year because of existing pay agreements with the trade unions co ncerned and ashortage of skilled labour for the mildew. need1. Is the initial NPV calculated correct2. Is the project viable reply whole kitYr 1 2 3 45Sales2,700,0002,700,0002,700,0003,186,000 3,186,000 Less significant (800,000)(840,000)(882,000)(926,000) (972,405) Labour(800,000)(880,000)(968,000)(1,064,800) (1,171,280) Net MCF1, cytosine,000980,000 850,0001,195,100 1,042,315Labour at 10% genuine at 5%Sales at 18% in years 4 & 5Yr Cash flowsMCC 15%PV0(3,000,000)1(3,000,000)11,100,0000.8696956,5602980,0000.7561740,9783850,0000.6575558,87541,195,1000.5718683,35851,042,3150.4972518,239The project is viable because it has a decreed NPV of N458,010The initial NPV calculated does not take into consideration the leeway is sales, material and labour because of inflation.SummaryWe have looked at the impact of inflation in capital investment appraisal. Inflation refers to the persistent increases in prices of goods and services thus affecting the financing needs if the organisation a s salubrious as its cost of debt and WACC. Inflation is treated in capital investment appraisal by discounting inflated values of future cash flows at the money cost of capital or real cash flows at real cost of capital.Review questionIdi araba town council plans to build a bridge over the local river to replace the existing ferry service. mental synthesis will hold up in one years time, that is 2006 and will take 4 yrs. It has planned to sub contract the building work to a major construction company and the best tender will request the council in a cash expense of N10m at the start of building and further payments of N5m each year until 2010 once completed, the annual livelihood cost for the bridge will be N1m per annum according to todays prices the annual cost is expected to rise with the general inflation rate of 7% p.a. In addition, a major overhaul is expected to be required after the first 15years of use, this will comprise N10m of material improver wage costs of a furt her N10m in current prices.Material prices are expected to rise with the general rate of inflation for the conterminous 16years and then remain constant wage cost is expected to increase by 6% over the general inflation rate for the contiguous 3years and then increase in line with general prices. The market rice beer rate the council consider relevant for the whole life of the project is 17.7%. You can imbibe that for calculation purpose the life of the bridge is infinite. The expected use of the bridge is 20,000 vehicles per day and toll sharpen is expected to increase in line with general inflation.Requireda. Calculate minimum toll efflorescence in the first year of operation necessary for the bridge to belong even over its life, and explain your treatment of inflation. Note Assume all annual cash flows arise on the last day of the relevant year. b. What other factors do you think the council should consider when deciding upon the toll charge? Note The statement that in add ition, a major overhaul is expected to be required after the first 15yrs of use should be interpret to mean at the end of the first 15years of use (i.e. year 20.5 +15) (ICAN , 1993) seat of government investment funds Analysis and imposeation measure is an important factor to consider when computing capital investment appraisal because of its implications on cash flows. Capital investment appraisal is based on after task incremental cash flows arising from the project. Thus, when appraising the viability of a project tax that has to be incorporate and then discounted at the relevant cost of capital.Corporation taxThis is supercharged on the profit make on projects that is positive cash flows and then discounted at the appropriate ruling rate. Currently in Nigeria, it is charged at 30%. It is usually charged on a preceding year basis because tax is expected to be remitted 6-11 months after the end of the period in which profit were earned. In capital investment appraisal we assu me a year lag for corporation tax payment, that is, tax on taxable profits made in year one will be deemed payable in year 2 except otherwise stated. Also, when losings are made on a project the losses are used to rationalize tax liability hence, it is treated as tax benefit. The amount by which tax is reduced is equivalent to cash inflow to the project.Investment Incentives This is given to encourage investment in fixed assets. The main types include investment readjustment and capital fitting.Investment fees are receivables which should be brought into the project appraisal in the period in which they are receivable. They are use to reduce the tax liability.Capital allowance- is available to reduce a tax liability if a business is carried on and it has a balance of qualifying capital expenditure. The reduction is treated as cash savings. Capital allowance could be treated on a true line basis or a reducing balance basis. In Nigeria it is exacted as initial allowance and a nnual allowance. The Nigerian law permits a company to leave at least N10 in its book as write down value for an asset that is not yet abandoned by the company. The Nigerian law also restricts the capital allowances a company can claim in any year of assessment to a certain percentage of the adjusted profit so that companies that have made profit can always increase their tax liability.On administration of an asset no capital allowance can be claimed in the year of disposal. When disposal is finally made, the difference between the proceeds on disposal and tax scripted down value treated as i. A balancing charge if the sales proceeds exceed the tax written down value. ii. A balancing allowance if the tax written down value exceeds the sales proceeds.Assumptions on Investment allowance and capital allowance claims Two possible assumptions can be made on when to deduct capital allowance claims i. We can assume that the first claim is set off on profits that occur in year one and i t is deductible in year 1 ii. The most acceptable by examiners and in practice is to assume that the first claim occurs in year one and the tax savings occur one year later that is, year 2.Illustration 1A company purchases a shapery at a cost of N10,000 in respect of a project which has a life of 5years and a residual value of N500. Calculate the capital allowance on a straight line basis that will be used to reduce tax payment in each year of the project. The initial allowance is 50% while the annual allowance is charge at 25%. form ClaimsPoolAllowance1. Initial allowance (50% x 10,000) 5,000 10,000Annual allowance (25% x 10,000)-5,000 -10) 1,247.50(6,247.5)6,247.52. written down value c/f3,752.5Annual allowance(1,247.5)1,247.53. written down value c/f2,505Annual allowance(1,247.50)1.247.54. written down value c/f1,257.5Annual allowance(1.247.5)1.247.55. written down value c/f10Sales proceed(500)Balancing charge 490(490)Illustration 2XYZ company is considering investing in plant and machinery costing N100,000. The machine has a life of 5 years after which it can be sold for N5,000. The machine would generate annual cost of saving of N35,000. Investment incentive on the machinery will be available as follows Investment allowance 20%, initial allowance 20%, annual allowance 10% on a straight line basis. Tax rate 35% payable one year in arrears and after tax cost of capital is 15%. Should the machine be purchased? beginningWorkingsInvestment allowance = 20% x 100,000 = N20,000Capital allowance computation. yr Claims Capital Tax written allowance N down value N1 Initial allowance ( 20% x 100,000)20,000Annual allowance(10% x 100,000) 20,000) 8,000 28,00072,0002 8,00064,0003 8,00056,0004 8,00048,0005 48,000 5000Computation of tax liability category 1 2 3 4 5Cost of savings35,00035,00035,00035,00035,000Investment allowance(20,000)-Capital allowance(28,000)(8,000)(8,000)(8,000)(43,000) Taxable profits13,00027,00027,00027,0008,000Tax at 35%4,550(9,450)(9,450)(9,450 )2,800Computation of NPVtwelvemonth Machinery Savings Tax Net cash DCF 15% PV 0 (N100,000)- (N100,000)1 (N100,000) 1 35,000 35,0000.869630,4362 35,000 4,550 39,5500.756129,903.763 35,000 (9,450) 25,5500.657516,799.134 35,000 (9,450) 25,5500.571814,609.495 50000 35,000 (9,450) 30,5500.497215,189.46 6 2,800 2,8000.43231,210.448,148.28The NPV is positive and thus, the machinery should be purchased.Illustration 3New ventures Nigeria Ltd is considering a project with an initial cost of N5m. The project is to last for 5years with a scrap value of N10,000 .The project involves the work and sales of overlap X. Estimated future sales quantity and fixed costs are given belowYearSales QtyFixed CostsUnitsN,0001100,0001,0002110,0001,1003120,0001,2004120,0001,2505125,0001,300The selling price of product X is expected to be N50 per unit in year 1 rising by 5% per annum because of inflation. Variable costs are expected to be N25 per unit in year 1 rising by 8% per annum because of inflation. Ge neral level of inflation in the rustic is before long 7.5%. The company can claim capital allowance at the rate of 20% on the reducing balance basis on this project. Tax is currently at the rate of 35% payable one year in arrears. If the companys after tax real cost of capital is 7%, should the company invest in the project?SolutionWorkingsComputation of cash profitYear Sales gross Variable cost (N) Fixed CostProfits(N) 1100,000(N50)100,000(25)1,000,0001,500,0002110,000(50)(1.05)110,000(25)(1.08)1,100,0001,705,0003120,000(50)(1.05)2120,000(25)(1.08)21,200,0001,915,800 4120,000(50)(1.05)3120,000(25)(1.08)31,250,0001,916,614 5125,000(50)(1.05)4120,000(25)(1.08)41,300,0002,045,386Computation of capital allowance(Reducing balance basis)Year Capital allowance Written down value 120% x 5,000,0001,000,0004,000,000220% x 4,000,000800,0003,200,000320% x 3,200,000640,0002,560,000420% x 2,560,000512,0002,048,00052,048,000 10,0002,038,000-Computation of tax liabilityYear 12345Profits1,500 ,0001,705,0001,915,8001,916,6142,045,386 Less cap allowance(1,000,000)(800,000)(640,000)(512,000) (2,038,000)500,000905,0001,275,8001,404,6147,386Tax 35% 175,000316,750446,530491,6152,585Cost of capital to use(1+m) = (1+r)(1+i)i+m = (1.07) (1.075)M = 1.15025 1M = 0.1503 x 100M = 15.03%Computation of NPVYear Cost/Residual Cash profits Tax liability Net cash flow DCF15.03% PV 0 (5,000,000) -(5,000,000) 1 (5,000,000) 1 1,500,000-1,500,000 0.86931,303,900 21,705,000(175,000)1,530,000 0.75571,156.221 31,915,800(316,750)1,599,050 0.65701,050,576 41,916,614(446,530)1,470,084 0.5712839,7125 10,0002,045,386(491,615)1,536,771 0.4965776,412 6(2,585) (2,585) 0.4317(1,116)125,755The company should ship on the project because it has positive NPVIllustration 4SCG limited is considering a project that has the following cash flow estimatesYearCash taxCash Operating Expenses1N000N00021,60090031,8001,10041,40060051,200500500200The project cost is N1.4m and has an estimated residual value of N10,5 00. The above cash flow profile has not taken into consideration the effect of changing prices. If effect on changing selling prices are taken into consideration cash revenue are expected to rise by 10% after year 1 and operating expenses by 11% after year 1. General level of inflation in the country is currently 15%.SCG Ltd can claim capital allowance at the rate of 25% on the reducing balance basis on this project. tax is currently at the rate of 35% payable one year in arrears. If the companys after tax cost of capital is 20%,should the company invest in the project? SolutionWorkingsComputation of cash profitYear Cash revenue (N) Operating expenses(N) Profits(N) 11,600,000 900,000700,00021,800,000(1.10) 1,100,000(1.11)759,00031,400,000(1.10)2 600,000(1.11)2 954,74041,200,000(1.10)3 500,000(1.11)3913,384.505 500,000(1.10)4 200,000(1.11)4428,435.92Computation of capital allowanceYear Capital allowanceWritten down value125% x 1,400,000350,0001,050,000225% x 1,050,000262,500 787,5003 25% x 787,500196,875 590,625425% x 590,625147,656.25 442,968.755N442,968.75 10,500432,468.75Computation of tax liability12345Profits 700,000 759,000 954,740 913,384.50 428,435.92 Less capital allowance 350,000 262,500 196,875 147,656.25 432,468.75 Taxable Profit 350,000 496,500 757,865 765,728.25 4032.83Tax 35% (122,500) (173,775) (265,252.75) (268,005)1,411.5Computation of NPVYear Cost/Residual Cash Profits Tax liability Net Cash flow DCF20% PV 0 (N1,400,000) (1,400,000)1 (N1,400,000) 1 700,000- 700,0000.8333583,3102759,000(N,122,500) 636,5000.6944441,9863954,740(173,775) 780,9650.5787451,9444913,385(265,253) 648,1320.4823312,5945 10,500428,436(268,005) 170,9310.4019 68,697 61,412 1,4120.3349 473459,004The company should embark on the project because it has a positive NPV SummaryThe effect of taxation on a project will be to increase or reduce tax liability a company pays to the tax sanction which will in turn increase or reduce the cash flows that will be used in arriving at th e NPV of the project. When taxation is reflected in the cash flows, a post tax cost of capital should be used in evaluating the viability of the project.Review questions1. Turnaround Nig Ltd is considering an investment that requires an outlay of N100,000 to be spent on the acquisition of necessary plant and machinery. The investment is expected to last for a period of 5 years by which time the residual value of plant and machinery is expected to be N18,000.The net revenue is estimated at Period 12345Net revenue 30,000 45,000 50,000 52,000 20,000In addition, turnaround Nigeria Plc expensed an investment of N10,000 in working capital and advertising expenses of N2,000 in period 1 and period 2.Turnaround Nigeria Plc has an after tax cost of capital of 10% and the application tax rate is 40% while the rates of capital allowance are initial allowance 20%,annual allowance 10%.Payment of tax claim may be assumed to be exactly one year in arrears.RequiredDetermine if the investment is univ ersal1. Links Ltd is considering investing in a project that will involve purchase of plant and machinery costing N150,000.The plant and machinery are expected to have a life span of 5 years and a residual value of N8,000. the project will generate cash profits as followsCapital allowance is available on the plant and machinery at the rate of 25% of cost on the reducing balance basis. Tax is currently payable at 35% payable one year in arrears. The companys after tax cost of capital is 18%.advise if the project is worthwhile.