Taxes and NPV
NPV calculation is not simple one. Complexities arise when the matter of taxation comes into the analysis. When doing DCF (Discounted Cash Flows) exercises, it is necessary to take effect of the taxes and for this, it is necessary to understand which cash flows get affected with the tax factor.
Cash flows not affected
- Initial investment cash flow does not get affected with tax,
- Working capital which is the difference of current assets and current liabilities also does not get affected with tax.
Cash flows affected
- The revenue cash inflows get affected with tax.
- The expenses cash outflows get affected with tax.
- Depreciation calculated using tax capital allowance method is affected by the tax rate.
Example
DCF is involved in the production of engine oils of various types to be used in cars, truck and heavy machines. It is considering investing in a plant and machinery which will increase its current capacity by 40 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}. In order to increase the production capacity, a written approval has already been obtained from the Government department costing $ 1,000.
The plant and machinery will cost $ 200,000 and has useful like of 05 years. Working capital required is $ 25,000. Annual after tax cash receipt is $ 25,000. Corporation tax rate is 20 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c} and discount rate for evaluation of this project is 10 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}.
Solution
We will ignore approval fees from Government because it has already been incurred and as a result, is a sunk cost.
| Year | 0 | 1 | 2 | 3 | 4 | 5 | NPV |
| Initial Investment | (200,000) | ||||||
| Working capital required | (25,000) | ||||||
| After tax cash receipts Working 1 | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 | ||
| Tax shieldWorking 2 | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 | ||
| Net Cash Flow | (225,000) | 40,000 | 40,000 | 40,000 | 40,000 | 40,000 | |
| Discount factor @ 10 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c} | 1.0 | 0.9091 | 0.8264 | 0.7513 | 0.6830 | 0.6209 | |
| (225,000) | 36,364 | 33,056 | 30,052 | 27,320 | 24,836 | (73,372) |
As the NPV (Net Present Value) is negative, DCF should reject the project for investment.
Workings
- After tax cash receipts: = annual tax receipts x (1 – tax rate) = 25,000 (1 – 0.20) = $ 20,000
- Tax shield: = Capital allowance x ( 1 – tax rate ) = 200,000 / 5 = 100,000 x ( 1 – 0.20) = $ 20,000