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Impact of Income Tax on Capital Budgeting

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Impact of Income Tax on Capital Budgeting

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Payment of tax and tax savings are cash flows which ought to be considered in evaluating a project because they have significant impact on the cash flow of a company. Tax payment or tax cost represents cash outflow while tax savings represent cash inflow.

 

Before explaining the effect of income tax on capital budgeting using a Net Present Value illustration, we need to understand three concepts namely after-tax cash inflow, after tax cash outflow and depreciation tax shield.

 

We can now explain the impact of income tax on the capital investment with the aid of a comprehensive illustration.

 

ILLUSTARTION 1

 

ABC Plc. is considering the acquisition of an item of machinery costing $480,000. The expected annual cash savings to be generated from the machinery is $200,000. Its useful life is 12years. The expected residual value (salvage value) is $60,000. The tax rate is 40% and discount rate is 12%.

 

The machinery is to be depreciated using straight line method.

 

You are required to compute NPV and advise the company whether to acquire the machinery or not.

 

 

SOLUTION

 

 

ABC Plc.

 

Years

Cash flow

Tax

Cash flow

D.F

PV

   

before tax

effect

after tax

12%

 
   

$

 

$

 

$

Cost of equipment

0

  (480,000)

 

 (480,000)

1

  (480,000)

Annual cash savings

1 to 12

    200,000

0.6

   120,000

6.1944

    743,328

Depreciation

1 to 12

      40,000

0.4

     16,000

6.1944

      99,110

Residual value

12

      60,000

0.6

     36,000

0.2567

        9,241

Net present value

         

    371,680

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The project should be accepted because it gives a positive NPV of $371,680.

 

Note: The residual value is regarded as cash inflow.

 

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