Unit 1-Lesson 4

LESSON 4
IMPACT OF TAXATION ON THE VIABILITY OF

CAPITAL INVESTMENT PROJECTS
ICE BREAKER
MOTIVATION
LESSON 5-LEARNING OUTCOMES
At the end of this lesson you should be able to:

• evaluate the impact of taxes on the viability of capital
investment projects.
QUICK QUIZ
• What are the impact of taxes on the viability of capital

investment projects?
DEALING WITH TAXATION
• Taxation may have a significant impact on the viability of capital
investment projects.
• Taxation payments and savings in tax payments are clearly cash flows
associated with the project. They are relevant and should be considered in
DCF analysis.
• Tax effects that we need to deal with:
Corporation tax
Capital Allowances, also known as Wear and Tear Allowance.
CORPORATION TAX ASSUMPTIONS
• Net cash flows from the project should be considered as the taxable profits
arising from the project.
• Depreciation is not an allowable deduction. It may be necessary to adjust
for depreciation.
• Timing of the payments – corporate tax will be in two instalments.
• Half of the tax will be payable in the year it is incurred and the balance in
the following year.
IMPACT OF TAXATION ON CASH FLOWS
• Taxation has the following effects on an investment appraisal

problem:
 Project cash flows will give rise to taxation which itself has an
impact on project appraisal.
 Organisations benefit from being able to claim wear and tear
allowances.
 The effect of these is to reduce the amount of tax that
organisations are required to pay.
WRITING DOWN ALLOWANCES (WDAS)
• These are not cash flows
• To calculate the tax impact, you multiply each year's WDA by the corporation tax
rate.
• The effect of a WDA is on the amount of tax payable, which is the relevant cash
flow.
• For example if your net cash flows (taxable profits) are N$20 000, corporation
tax rate is 30%:
 a) No WDAs;
 Tax payable is N$6 000 (30% of 20 000)
WRITING DOWN ALLOWANCES (WDAS)
b) WDAs of 10% per year;

WDAs = 10% of 20 000 = 2000
Tax impact = 30% of 2000 = 600
Tax payable = 6000 – 600 = 5 400
• This means you have gained N$600 as a result of
WDAs.
ASSUMPTIONS IN DEALING WITH TAX EFFECTS
• Where a tax loss arises from the project, there are

sufficient taxable profits elsewhere in the organisation to
allow the loss to reduce any relevant (subsequent) tax
payment (and it may therefore be treated as a cash inflow)
• The company has sufficient taxable profits to obtain the
full benefit from wear and tear allowances.
CAPITAL ALLOWANCES (WEAR AND TEAR
ALLOWANCE)
• Wear and tear allowance (WTAs) is used to reduce

taxable profits, and the consequent reduction in a tax
payment should be treated as a cash saving arising from
the acceptance of the project.
BALANCING ALLOWANCE
• When the plant is eventually sold, there may be

differences between the reducing balance amount and
the selling price of the asset.
• An appropriate adjustment must be made to ensure that
the company receives allowances equal to the total
allowance allowed (i.e. purchase price less final value).
EXAMPLE
• An asset is purchased for N$50 000. At the end of the fourth year it will be
sold for N$10 000.Writing down allowances are 25% reducing balance and
corporation tax is 30%. Corporation tax is paid in two instalments, with half
the tax payable in the year in which it arises, and the balance paid in the
following year.
Required
Calculate the capital allowances each year and the associated corporation tax
savings
Illustrate the timing of the tax savings calculated in part (a).
EXAMPLE FEEDBACK
Year Reducing balance Capital allowance @ 25% Tax saved @ 30%
0 50,000 - -
1 37,500 12,500 3,750
2 28,125 9,375 2,813
3 21,094 7,031 2,109
4 10,000 11,094 3,328
Year Cash benefit received Total

1 1,875 1,875
2 1875 + 1407 3,282
3 1407 + 1055 2,462
4 1055 + 1664 2,719
5 1,664 10 338
EXERCISE
• Cymot plc. has produced and marketed sleeping bags for several years.
The sleeping bags are much heavier than some modern sleeping bags
being introduced to the market. The company is concerned about the effect
this will have on its sales.
• Cymot plc. are considering investing in new technology that would enable
them to produce much lighter and more compact sleeping bags. The new
machine will cost N$250 000 and is expected to have a life of four years
with a scrap value of N$10 000. In addition an investment of N$35 000 in
working capital will be required initially.
EXERCISE
• The following forecast annual trading account has been prepared for the project:
N$
 Sales 200 000
 Material (40 000)
 Labour (30 000)
 Variable overheads (10 000)
 Depreciation (20 000)
 Annual profit 100 000
EXERCISE
• The company’s cost of capital is 10%. Corporation tax is charged

at 30% and is paid in two equal instalments, with half payable in
the year which it arises, and the balance paid in the following year.
A writing down allowance of 25% on reducing balance is available
on capital expenditure.
Required:
• Calculate whether Cymot plc. should invest in the new technology.
EXERCISE FEEDBACK
Reducing Capital allowance @ Tax saved
Year balance 25% @30% Benefit received Total cash benefit
0 250,000
1 187,500 62,500 18,750 9,375 9,375
2 140,625 46,875 14,063 9375+7032 16,407
3 105,469 35,156 10,547 7032+5274 12,306
4 10,000 95,469 28,641 5274+14321 19,595
5 14,321 14,321

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LESSON 4

IMPACT OF TAXATION ON THE VIABILITY OF

At the end of this lesson you should be able to:

• What are the impact of taxes on the viability of capital

• Taxation has the following effects on an investment appraisal

b) WDAs of 10% per year;

• Where a tax loss arises from the project, there are

• Wear and tear allowance (WTAs) is used to reduce

• When the plant is eventually sold, there may be

Year Cash benefit received Total

• The company’s cost of capital is 10%. Corporation tax is charged

1 187,500 62,500 18,750 9,375 9,375

2 140,625 46,875 14,063 9375+7032 16,407

3 105,469 35,156 10,547 7032+5274 12,306

4 10,000 95,469 28,641 5274+14321 19,595

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