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

Inflation refers to persistent step-up in price of goods and services. It is alike referred to as average command change magnitudes in the price of goods and services. Prior to this time, there had been lots of argument amongst writers in finance on whether or not to trend or include splashiness when computing large(p) budgeting. The argument has always being that ostentation affects both the bank discount valuate and the hard change emanate and then the effect exit always bottomlandcel out.During inflation sh beholders will always demand for higher serve up of return because inflation has a way of wearing away the purchasing power of the shareholders but the come to of inflation on the companionships send of return and the evaluate cash flow are not always the same. Shareholders are not likely to reflect the entire inflation rate on a single investment funds because of risk diversification outline employed by most shareholders.Besides, inflation will not affe ct all the cash flows in incisively the sameway. The impact of inflation on labour for instance will not be the same for material live and cannot automatically reflect on selling price. Whichever way it is, the question is, How do we incorporate the effect of inflation in great(p) investment decisions? How do we adjust for inflation?Will the upchuck still be worthwhile by and byward adjusting for inflation?In analysing the effect of inflation in chapiter budgeting analysis two things should be taken into contemplation. i. The effect of inflation on the discount rate As inflation make ups shareholders will demand for increased return to compensate for the reduction in the judge of their capital. 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 cash flows.There are fundamentally two types of inflationi. 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 cash 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 see to it under consideration. Various components such as sales prices, labour price, inconstant monetary value etc. Specific inflation affects only the cash flows of the bedevil. The treatment of specific inflation should be detailed as possible.Money Cash flow and Real Cash flow In an inflationary period there is a difference amongst N10,000 cash and goods and services worth N10,000. The beginning(a) is the gold cash flow while the later is genuinely cash flow.Money Cash flow refers to the actual amount of cash flows in token(a) term. To enter at the bullion cash flow we adjust each item by its specific rate of inflation.Real Cash flow on the separate hand refers to purch asing power equivalent of the actual amount of cash flows. To arrive at the concrete cash flows we deflate (i.e. discount) money cash flows utilise the general rate of inflation.In digest appraisal, general inflation is usually assumed 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 Cost of Capital (MCC) & Real Cost of Capital(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 constant price level terms. Return on an investment are usually based on evaluate returns. The expect rate of inflation will be reflected in required rate of return for a project. 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 toll of capitalR= sincere cost of capitalI = General rate of inflationFrom the equation above, 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 calculated as r = 1If m and r are given, then 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 stated 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 relevant cost of capital which in most cases is the money cost of capital except otherwise stated. 5. Money cash flow s 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 costing N50,000. The project is expected to have a life of 4 categorys with a residual value of N4,000. Annual cash r compensateue from the project is expected to be N35,000 in year 1 rising by 6% per annum for inflation. Running cost are expected to be N15,000 in the first year of the project but would increase by 11% per annum because of inflating labour costs. The general rate of inflation is expected to be 8% and the companys money cost of capital is 18%. Advice the company 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 contribution without incurring any additional fixed cost but with a nil residual value at the end of year 4. Cumulative discount rate at 15% for 5years is 3.352. The companys 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 one-year sales of N2.7m and variable costs of N1.6m for 1million units of sales per annum.These are the expected money value in year one. b. The sales would be do through a single distributor, who has asked for a fixed selling price of N2.70 per unit for 3yrs by and byward which prices could increase by 18% for year 4 and held constant for year 5 c. protean 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 rise by an expected 10% per annum for each year because of existing wage agreements with the trade unions concerned and ashortage of skilled labour for the counterfeit.Required1. Is the initial NPV calculated correct2. Is the project viable effectWorkingsYr 1 2 3 45Sales2,700,0002,700,0002,700,0003,186,000 3,186,000 slightMaterial (800,000)(840,000)(882,000)(926,000) (972,405) Labour(800,000)(880,000)(968,000)(1,064,800) (1,171,280) lolly MCF1,100,000980,000 850,0001,195,100 1,042,315Labour at 10%Material 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 positive NPV of N458,010The initial NPV calculated does not take into consideration the adjustment 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 as well as its cost of debt and WACC. Inflation is treat 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 capi tal.Review questionIdi araba town council plans to build a bridge over the local river to replace the existing ferryboat service. Building will start in one years time, that is 2006 and will take 4 yrs. It has planned to sub contract the build work to a major construction company and the best tender will involve 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 maintenance 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 plus wage costs of a further N10m in current prices.Material prices are expected to rise with the general rate of inflation for the next 16years and then remain constant wage cost is expected to increase by 6% over the general inflation rate for the next 3y ears and then increase in line with general prices. The market interest rate the council consider relevant for the whole life of the project is 17.7%. You can assume 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 charge is expected to increase in line with general inflation.Requireda. Calculate minimum toll charge in the first year of operation necessary for the bridge to break even over its life, and explain your treatment of inflation. Note Assume all annual cash flows arise on the run short 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 addition, a major overhaul is expected to be required after the first 15yrs of use should be interpreted to mean at the end of the first 15years of use (i.e. year 20.5 +15) (ICAN , 1993)Capital investiture Analysis and revenueationTax 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 impose that has to be incorporated and then discounted at the relevant cost of capital.Corporation imposeThis is charged on the profit made 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 assume a year lag for corporation tax payment, that is, tax on taxable win made in year one will be deemed payable in year 2 except otherwise stated. Also, when losses are made on a project the losses are used to reduce tax liability hence, it is treated as tax benefit. The am ount 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 gross profit and capital allowance.Investment allowances 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 uncommitted 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 straight line basis or a reducing balance basis. In Nigeria it is claimed as initial allowance and annual allowance. The Nigerian law permits a company to leave at least N10 in its book as pen follow through value for an asset that is not yet disposed 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 disposal 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 written down value treated as i. A balancing charge if the sales proceeds hand 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 it 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. good example 1A company purchases a machinery at a cost of N10,000 in respect of a p roject 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%. social class 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 expend 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?SolutionWorkingsInvestment allowance = 20% x 100,000 = N20,000Capital allowance computation.Year 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 liabilityYear 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 NPVYear 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) 3 0,5500.497215,189.46 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 production and sales of product X. Estimated future sales quantity and fixed costs are given on a lower floorYearSales 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 quantity costs are expected to be N25 per unit in year 1 rising by 8% per annum because of inflation. General level of inflation in the country is presently 7.5%. The company can claim capital allowance at the rate of 20% on the reducing balance basis on this project. Tax is soon at the rate of 35% payable one year in arrears. If the companys after tax re al cost of capital is 7%, should the company invest in the project?SolutionWorkingsComputation of cash profitYear Sales Revenue 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 1 M = 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 embark on the project because it has positive NPVIllustration 4SCG limited is considering a project that has the following cash flow estimatesYearCash revenueCash Operating Expenses1N000N00021,60090031,8001,10041,40060051,200500500200The project cost is N1.4m and has an estimated residual value of N10,500. 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 1,050,000262,500 787,500325% 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 P rofit 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 tax on a project will be to increase or reduce tax liability a company pays to the tax authority which will in turn increase or reduce the cash flows that will be used in arriving at the 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 skill 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 rank 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 worldwide1. 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 fo llowsCapital 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.