Question 7.EX.2.4.1: NPV calculation involving taxation Bent plc is considering...
NPV calculation involving taxation
Bent plc is considering buying a new machine costing £200,000 which would generate the following before-tax cash flows from the sale of goods produced.
\begin{array}{cc}\text { Year } & \text { Before-tax cash flow } \\1 & £ 65,000 \\2 & £ 70,000 \\3 & £ 75,000 \\4 & £ 98,000\end{array}Bent pays corporation tax of 20 per cent per year one year in arrears and is able to claim capital allowances on a 25 per cent reducing balance basis. The machine would be sold after four years for £20,000. If Bent’s after-tax cost of capital is 10 per cent, is the purchase of the machine financially acceptable?
The capital allowances were calculated in Table 7.1. The tax liabilities can be found by subtracting the capital allowances from the before-tax cash flows to give taxable profits and then multiplying taxable profits by the tax rate:
\begin{array}{lc}&£\\\text { Year 1 (taken in Year 2): }(65,000-50,000) \times 0.2= & 3,000 \\\text { Year 2 (taken in Year 3): }(70,000-37,500) \times 0.2= & 6,500\\\text { Year 3 (taken in Year 4): }(75,000-28,125) \times 0.2= & 9,375 \\\text { Year 4 (taken in Year 5): }(98,000-64,375) \times 0.2= & 6,725\\ \end{array}The calculations of the net cash flows and the net present value of the proposed investment are shown in Table 7.2. The NPV is a positive value of £22,226 and so purchase of the machine by Bent plc is financially acceptable.
Table 7.1 Capital allowances on a 25 per cent reducing balance basis on a machine costing £200,000 which is purchased at year 0. The expected life of the machine is four years and its scrap value after four years is £20,000. Corporation tax is 20 per cent, payable one year in arrears.
\begin{array}{|c|c|c|}\hline & £ & £ \\\hline {\text { Calculation of capital allowances: }} \\\hline \text { Year 1: } 200,000 \times 0.25= & & 50,000 \\\hline \text { Year 2: }(200,000-50,000) \times 0.25= & & 37,500 \\\hline \text { Year 3: }(200,000-50,000-37,500) \times 0.25= & & 28,125 \\\hline \text { Year 4: }(200,000-50,000-37,500-28,125) \times 0.25= & & 21,094 \\\hline \text { Initial value }= & 200,000 & \\\hline \text { Scrap value }= & \underline{20,000} & \\\hline \text { Value consumed by the business over } 4 \text { years }= & {180,000} & \\\hline \text { Sum of capital allowances to end of Year } 4= & \underline{136,719} & \\\hline \text { Year } 4 \text { balancing allowance }= & & \underline{43,281} \\\hline \text { Total capital allowances over } 4 \text { years }= & & \underline{180,000} \\\hline \text { Calculation of taxation benefits: } & £ & \\\hline \text { Year } 1 \text { (taken in Year 2): } 50,000 \times 0.2= & 10,000 & \\\hline \text { Year } 2 \text { (taken in Year 3): } 37,500 \times 0.2= & 7,500 & \\\hline \text { Year } 3 \text { (taken in Year 4): } 28,125 \times 0.2= & 5,625 & \\\hline \text { Year } 4 \text { (taken in Year 5): }(21,094+43,281)=64,375 \times 0.2= & \underline{12,875} & \\\hline \text { Total benefits (should equal } 180,000 \times 0.2=36,000 \text { ) } & \underline{36,000} & \\\hline\end{array}Table 7.2 Calculation of net cash flows and net present value for Bent plc
\begin{array}{|c|c|c|c|c|}\hline \text { Year } & \text { Capital }(£) & \text { Operating cash flows }(£) & \text { Taxation }(£) & \text { Net cash flows }(£) \\\hline 0 & (200,000) & & & (200,000) \\1 & & 65,000 & & 65,000 \\2 & & 70,000 & (3,000) & 67,000 \\3 & & 75,000 & (6,500) & 68,500 \\4 & 20,000 & 98,000 & (9,375) & 88,625 \\5 & & & (6,725) & (6,725) \\\hline\end{array}\begin{array}{|c|c|c|c|}\hline \text { Year } & \text { Net cash flows }(£) & 10 \% \text { discount factor } & \text { Present value }(£) \\\hline 0 & (200,000) & 1.000 & (200,000) \\1 & 65,000 & 0.909 & 59,085 \\2 & 67,000 & 0.826 & 55,342 \\3 & 68,500 & 0.751 & 51,444 \\4 & 88,625 & 0.683 & 60,531 \\5 & (6,725) & 0.621 & \underline{(4,176)} \\& & \text { Net present value } & 22,226 \\\hline\end{array}