LEARNING OBJECTIVE

If a company borrows to finance its operations,

|the bank's lending rate may not be the real
Chapter g cost to the company. Interests on such debts
|are allowable deductions when computing the
TAXATION IN INVESTMENT company's tax liability. This invariably reduces
APPRAISAL the COst of borrowing.
Claims on capitalallowances granted in place
|of depreciation are also considered when
appraising projects.Readers will appreciate the
|import of tax at the end of this chapter.
Taxation has so far been ignored in all the appraisals considered. However, a company will
have a potential liability to pay tax on all profits. Tax is the cash payment and its effects are
relevant to an investment decision using the DCF criterion. In practice, tax is calculated on
the adjusted profit and if information is given in the question as to the expected profit, the tax
payable will be calculated as accurately as possible.

Cash inflow gives rise to cash outflow by way of tax at the company's tax rate in the
same
way that additional receipts will give rise to tax payment as additional cost will give way to
tax savings.
Alsosince depreciation is disallowed because of lack of uniformity, capital allowance (tax
depreciation) shall be applied at the ratesgiven for tax savings in respect of qualifyingcapital
expenditure.

These allowances include:

Initial allowance
2 Annual allowance
3 Balancing allowance
4 Balancing charge

Expenditures on working capital are assumed not to have corporation tax implications
Soever. what

Unless otherwise stated, tax is assumed to be

rise to it occurred. This invariably increasespayable one year after the flow which gave
the lifespan ofa project by one year.

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Chapter9 Tuxation In hnvestnentAppraisal

AREAS WHERE TAX HAVE A SIGNIFICANT

INFLUENCE IN FINANCIAL MANAGEMENT
Capital budget i.e effect on cash flovwsand on the profitabilityof an investment.
will
2. Cost of capital. Introducing taxation effect into cost of capitalcalculation
make loan cheaper as interest payable on loan is tax deductible.
3
Short term cash budget i.e pavment of tax on profit and payment of other taxes like
PAYE will affect cash flow in a short term.

SUMMARY
and the
Ihe implication of tax on essential items will need to be appreciated. Such items
tax implication on them are:
Itenn Tax effect
RevenLe Tax payment
2 Cost Tax savings
3 Capital Allowance Tax savings
4 Balancing Allowance Tax savings
Balancing Charge Tax payment
No effect
6.
Working (apital
QUESTION 9-1:
Jalingo Nigeria Plc is considering an investment that requires an outlay of N100,000 to be
spent on theacquisition of necessary plant and machinery.

The investiment is expectedtolast for a periodof 5 years by which time the residual value of
the plant and machinery is expected to be N18,000.
The net revenue is estimated at

2 3 4 5
Period
Net revenue (N)30,000 45,000 50,000 52,000 20,000

Inaddition, JalingoNigeria Plc. expensed an investment of N10,000 in working capital and

advertising expenses ofN2,000 in period l and N3,000 in period2.

Jalingo Nigeria Plc has an after tax cost of capital of 10% and the applicable tax rate is 40%
while the rates of capital allowances are 20/10.
Timingof tax claims / payments may be assumed to arise exactly one year in arrears.
Determine whether the investment is worthwhile.

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 Chapter 9
luxation In Investment Appraisul
SOLUTION 9-1:
COMPUTATION OF NPV
Yr CF Tax DCF 10% PV
0
(l10,000) (10.000)
28,000 0.909 25,452
42.000 0.826 34,692
50,000 13,600 0.751 27,336
S2.000 16,800 0.683 24,042
48.000 17,600 0.621 18,878
4,000 0.564 2.256
22,656
Decision: The project is worthwhile since it has a positive NPV of
N22,656.
Workings
() Computation of capital Allowvances
Cost 100,000
Yr l Initial (20,000)
Annual (8,000)
TWDV 72,000
Yr 2 (8,000)
TWDV 64.000
Yr 3 (8,000)
TWDV 56.000
Yr 4
(8,000)
TWDV 48,000
Yr 5
(30,000)
Scrap value 18,000
2
Compilation of tax liability
Yr
2 4
Revenue 5
30,000 45,000 50,000 52,000
Less: Advert Exp. (2,000) 20.000
Net Revenue (3,000)
28.000 42,000 50,000
Less C/A 52,000 20,000
(28,000) (8,000) (8,000)
Taxable Profit (8,000) (30,000)
Tax 40%
34,000 42,000 44,000 (10,000)
Payable 2
(13,600) (16,800) (17.600) 4.000
3 4
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 Chapter 9 Taxation lnnvestment Appraisal

QUESTION 9-2
Bomboy Plc plans to builda new plant at a cost of N100,000. The cost is made up of the
landing cost of the necessary machinery and the cost of installation. The plant is expected to
last 4 years.
It is expected to generate annual sales ofN70,000 with annual cash expenses of N20,000.
Allexpenses will be paid for at the end of the year to which they relate. However, sales
revenue willbe received as cash flows in the following manner:

75% of each year's sales at the end of that year;

25% of each year's sales received one year later;

Assume that allexpenses are tax deductible and that the company is a manufacturing con
cern.

Cost of capital is 10% and tax rate is 45%. Assume one year delay in tax. For capital
allowances purposes, assume an initial allowance of 20%and an annual allowance of 10%
straight-line over ten years.
Bomboy Plc is avery profitable firm and can utilise allcapital allowances in full at the
earliest opportunity.
REQUIRED:
a Calculate the NPV of the project:
b) By paying a single lump sum now, the company could obtain the services of a
credit consultantwho would assure that all sales revenues were received in cash in
the year of sale.
Ascertain the maximum amount it would be worth paying for the services of the
credit consultant if such payments were tax deductible expenses.
SOLUTION 9-2
(a) Year CF Tax NCF DF@I0% PV
(100,000) (100,000) (100,000)
1 32,500 32,500 .91 29,575
2 50,000 (9,900) 40,100 .83 33,283
3 50,000 (18,900) 31,100 .75 23,325
4 50,000 (18,900) 31,100 .75 21,148
17,500 2,700 20,200 .62 12,527
19.855

(b) If the credit consultant is recruited, there will be the following incremental
cash flows.

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financial management
 Chpter9 Tuxation In Imvestment Appraial
Yr
3 4 5
N N N
Revenue 70,000 70.000 70,000 70,000
Cash collected (52,500) (70,000) 70,000 70,000 (17,500)
17,500 NIL NIL NIL (17,500)
The maximum sum pavabl is the py of these incremental cash flows. i.e.
Yr CF DF@T0% PV
17,500 .91 15,925
(17,500) .62 (10,850)
5,075
Workings.
1. Computation of CapitaiAllowances
N Total C/A
Cost 100,000
Yr |l.A (20,000)
A.A (8,000) 28,000
72,000
Yr 2 C/A (8,000) 8,000
64,000
Yr 3 C/A (8,000) 8,000
56,000
Yr 4 C/A (56,000) 56,000
NIL

2. Computation of tax liability.

Year I 2 3 4
Sales (Not receipt) 70,000 70,000 70,000 70,000
Expenses (Not payments) (20,000) (20,000) (20,000) (20,000)
Profit 50,000 50,000 50,000 50,000
Less Capital Allowarco (28,000) (8.000) (8,000) (56,000)
22,000 42,000 42,000 (6,000)
asp-yable) / Receivable
3% (9,900) (18,900) (18,900) 2,700
car (Payable) /Receivable 2 3 4

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