NPV calculation involving taxation Bent plc is considering buying a new machine costing

Question

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.

[latex]\begin{array}{cc} ext { Year } & ext { Before-tax cash flow } \1 & £ 65,000 \2 & £ 70,000 \3 & £ 75,000 \4 & £ 98,000\end{array}[/latex]

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?

Accepted Answer

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:

[latex]\begin{array}{lc}&£\ ext { Year 1 (taken in Year 2): }(65,000-50,000) imes 0.2= & 3,000 \ ext { Year 2 (taken in Year 3): }(70,000-37,500) imes 0.2= & 6,500\ ext { Year 3 (taken in Year 4): }(75,000-28,125) imes 0.2= & 9,375 \ ext { Year 4 (taken in Year 5): }(98,000-64,375) imes 0.2= & 6,725\ \end{array}[/latex]

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.

Question 7.EX.2.4.1: NPV calculation involving taxation Bent plc is considering...

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