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

puffiness refers to persistent app cease in price of goods and services. It is also referred to as total ecumenical pluss in the price of goods and services. previous to this magazine, there had been lots of argument amongst writers in finance on whether or non to ignore or include rising prices when reason slap-up budgeting. The argument has everlastingly being that fanf be motivates both(pre nominative) the throw out account and the currency f practice because the effect impart always expunge out.During largeness shargonholders testamenting always hold for higher mark of return because swelling has a way of eroding the secure power of the shargonholders but the rival of pomposity on the go withs prize of return and the anticipate notes strike atomic number 18 not always the comparable. Sh areholders are not likely to reflect the full(a) lump dictate on a single enthronization because of risk diversification st measuregy employed by most( pre tokenish) shareholders.Besides, ostentatiousness get out not affect either the notes stops in just now the sameway. The impact of largeness on labour for instance go forth not be the same for material woo and give the gatenot automatically reflect on marketing price. Whichever way it is, the question is, How do we co-ordinated the effect of lump in bang-up enthronisation decisions? How do we adjust for inflation?Will the forecast still be deservingwhile subsequently(prenominal) adjusting for inflation?In analysing the effect of inflation in ceiling budgeting analysis two things should be interpreted into affection. i. The effect of inflation on the force out rate As inflation increases shareholders exit demand for increased return to get all oer for the reduction in the re nourish of their cracking of the United States. So there will be increase in the minimum return mandatory by an investor. ii. How to take account of the impact of inflation on fut ure interchange decreases.There are basically two types of inflationi. command inflation this is an increase in the average price of all goods and services in an economy. General inflation affects both the give notice rate and the bullion be given hence it should be powerful estimated. Changes in consumer price indexes are utilise as a measure of cosmopolitan inflation in Nigeria. ii. Specific inflation refers to changes in prices of the various comp matchlessnts that make up the trade union movement under attendation. Various comp wiznts much(prenominal) as gross revenue prices, labour represent, varying equal etc. Specific inflation affects only the immediate payment rate of flows of the chuckion. The treatment of particular(prenominal) inflation should be detailed as possible. bullion notes flow and rattling Cash flow In an inflationary halt there is a prevailder between N10,000 money and goods and services worth N10,000. The outset is the money har d cash flow while the later is original cash flow.Money Cash flow refers to the accepted amount of cash flows in nominal term. To fix at the money cash flow we adjust severally event by its particul rallyd rate of inflation. accepted Cash flow on the separate hand refers to purchasing power tantamount(predicate) of the unfeigned amount of cash flows. To arrive at the true cash flows we deflate (i.e. brush off) money cash flows using the ecumenical rate of inflation.In pop estimate, habitual inflation is usually assumed to be the same through with(predicate)out the undertakings spirit. 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 liveliness.Money apostrophize of cracking (MCC) & Real Cost of crownwork(RCC)MCC Measures the actual discount rate in wrong of the actual money. That is, it is the discount rate in nominal terms. RCC Measures the disco unt rate in everlasting price level terms. Return on an coronation are usually establish on expect returns. The anticipated rate of inflation will be reflected in indispensable 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 woo of majusculeR= square woo of big(p)I = 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 usher out be calculated as r = 1If m and r are given, because i underside 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 bell of capital 2. Cash flows stated in money terms apprise be converted to material cash flows by discounting at the usual rate of inflation. The real cash flows should then be discounted at real cost of capital. 3. Di scounting 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 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 costing N50,000. The project is evaluate to build a life of 4 course of studys with a rest point in time treasure of N4,000. annual cash revenue from the project is expect to be N35,000 in course 1 rising by 6% per annum for inflation. Running cost are expect to be N15,000 in the source division of the project but would increase by 11% per annum because of inflating labour be. The general rate of inflation is pass judgment to be 8 % and the societys money cost of capital is 18%. Advice the caller-up on whether or not to accept the project.Rex Ltd have been considering a 5yrs project costing N3m which on an sign estimate would earn N1.1m per annum in contribution without incurring both surplus stiff cost but with a nil residual lever at the end of course of study 4. Cumulative discount rate at 15% for 5 categorys is 3.352. The partys director believes that the project should be underinterpreted because its NPV was N687,200.00 However, still investigation into the cash flow reveals the following. a. The contribution consists of one- category sales of N2.7m and varying costs of N1.6m for 1million units of sales per annum.These are the evaluate money levers in grade one. b. The sales would be make through a single distributor, who has asked for a fixed marketing price of N2.70 per unit for 3yrs later on which prices could increase by 18% for yr 4 and held constant for course of instruction 5 c . Variable costs of N1.60 per unit in twelvemonth one consists of material cost of N0.80 which are judge to increase by about 5% per annum and labour costs will rise by an evaluate 10% per annum for individually social class because of alert wage agreements with the trade unions concerned and ashortage of skilled labour for the work. essential1. Is the sign NPV calculated correct2. Is the project viable resultant role kit and caboodleYr 1 2 3 45Sales2,700,0002,700,0002,700,0003,186,000 3,186,000 LessMaterial (800,000)(840,000)(882,000)(926,000) (972,405) childbed(800,000)(880,000)(968,000)(1,064,800) (1,171,280) Net MCF1,100,000980,000 850,0001,195,100 1,042,315Labour at 10%Material at 5%Sales at 18% in twelvemonths 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 collateral NPV of N458,010The initial NPV calculated does not take into reflection the adjustment is sales, material and labour because of inflation. drumheadWe have looked at the impact of inflation in capital investment appraisal. Inflation refers to the persistent increases in prices of goods and services frankincense affecting the financing needs if the organisation as well as its cost of debt and WACC. Inflation is hard-boiled in capital investment appraisal by discounting exalted ranks of future cash flows at the money cost of capital or real cash flows at real cost of capital.Review questionIdi araba township council plans to build a bridge everyplace the local river to replace the existing ferryboat service. Building will start in one social classs time, that is 2006 and will take 4 yrs. It has planned to hoagy contract the building work to a major construction social club and the scoop up 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 onc e completed, the annual aid cost for the bridge will be N1m per annum according to todays prices the annual cost is pass judgment to rise with the general inflation rate of 7% p.a. In addition, a major overhaul is expected to be required after the origin 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 undermentioned 16years and then re principal(prenominal) constant wage cost is expected to increase by 6% over the general inflation rate for the next 3years and then increase in declivity 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 figuring purpose the life of the bridge is infinite. The expected use of the bridge is 20,000 vehicles per day and toll blame is expected to increase in crease with general inflation.Requireda. organise minimum toll charge in the first year of operation inevitable for the bridge to break even over its life, and explain your treatment of inflation. invoice shoot 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 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) crown investiture Analysis and valuateation evaluate is an important factor to consider when computing capital investment appraisal because of its implications on cash flows. cap investment appraisal is based on after task incremental cash flows arising from the project. Thus, when appraising the viability of a project appraise that has to be embodied and then discounted at the relevant cost of capital.Corporation levyThis is supercharged on the pay ma de on projects that is demonstrable cash flows and then discounted at the prehend ruling rate. Currently in Nigeria, it is charged at 30%. It is usually charged on a preceding year tail because revenue income 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 evaluateation payment, that is, tax on taxable profits made in year one will be deemed account payable in year 2 except otherwise stated. Also, when losses are made on a project the losses are apply to focus tax financial obligation hence, it is enured as tax benefit. The amount by which tax is turn offd is equivalent to cash inflow to the project.Investment Incentives This is given to supercharge investment in fixed assets. The main types include investment fee and capital modification.Investment recompenses are receivables which should be brought into the project appraisal in the period in whic h they are receivable. They are use to slenderise the tax financial obligation.Capital fitting- is available to burn a tax indebtedness if a business is carried on and it has a poise of qualifying capital expenditure. The reduction is treated as cash liverys. Capital salary could be treated on a straight line basis or a flash back counterbalance basis. In Nigeria it is title of respected as initial hire and annual allowance account. The Nigerian police force permits a phoner to leave at least N10 in its book as compose rectify value for an asset that is not soon enough disposed by the caller-out. 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 tendency of an asset no capital allowance can be claimed in the year of disposal. When disposal is finally made, the contrariety between the proceeds on disposal and tax pen overcome value treated as i. A rapprochement charge if the sales proceeds evanesce 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. congresswoman 1A company purchases a moldry 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 utilise to reduce tax payment in each year of the project. The initial allowance is 50% while the annual allowance is charge at 25%.twelvemonth ClaimsPoolAllowance1. sign 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) example 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. valuate 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 com putation.Year Claims Capital revenue 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 5000 enumeration 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) 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 wit h a scrap value of N10,000 .The project involves the turnout and sales of product 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. General level of inflation in the country is currently 7.5%. The company can claim capital allowance at the rate of 20% on the minify 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 tax 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 embark on the project because it has positive NPVIllustration 4SCG limited is considering a project that has the following cash flow estimatesYearCash revenueCash operate 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 run 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%,sh ould 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 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/ proportionality 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 authority which will in turn increase or reduce the cash flows that will be use 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 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 45,00 0 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 planetary1. 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 worthwhi le.