Step 3. Calculate MIRR using the formula
4.4 Tax-allowable depreciation (capital allowances)
When a business buys a non-current asset, depreciation is charged in the financial accounts. However, depreciation in the financial accounts is not an allowable expense for tax purposes.
Instead, the tax rules provide for ‘tax-allowable depreciation’ or capital allowances, according to rules determined by the government.
Tax-allowable depreciation affects the cash flows from an investment, and the tax effects must be included in the project cash flows.
There are two ways of allowing depreciation for tax purposes.
straight line method
reducing balance method.
Straight-line method
With the straight-line method, the amount allowed for tax purposes is a constant amount each year. The tax-allowable depreciation is calculated as:
=(The cost of the asset minus any expected residual value)
Expected years of life .
Example
An asset costs $80,000 and has an expected economic life of four years with no residual value.
If depreciation is allowed for tax purposes over four years using the straight-line method, the allowable depreciation would be $20,000 each year.
If the rate of tax on profits is 25%, the annual reduction in tax from the capital allowance is $20,000 × 25% = $5,000 for four years.
These cash flows should be treated as cash inflows for the project.
The reducing balance method
With the reducing balance method, the tax allowable depreciation is a constant percentage each year of the written down value (WDV) of the asset as at the beginning of the year. The WDV of the asset is its cost less all accumulated capital allowances to date.
The reducing balance method is much more likely to feature in an examination question on DCF than the straight-line method.
Example
A company purchases an asset costing $80,000. Tax-allowable depreciation is 25%
on a reducing balance basis. Tax on profits is payable at the rate of 30%. Tax is payable/saved one year in arrears.
It should be assumed that the first claim for tax-allowable depreciation is made against the profits of the company for Year 1.
Required
(a) Calculate the tax-allowable depreciation (capital allowances) that would be claimed against profits of Year 0 to Year 4, the tax saving, and the year of the cash flow benefit from the tax saving.
(b) Calculate the effect on tax if the asset is sold in Year 5 for $24,000.
Answer
(a) The capital allowances for Years 1 – 4, and their effect on cash flows, are calculated as follows:
Year
WDV at start of year
Tax allowable depreciation (25%)
Tax saved (30%)
Year of cash flow benefit
$ $ $
1 80,000 20,000 6,000 2
2 (80,000 – 20,000) 60,000 15,000 4,500 3 3 (60,000 – 15,000) 45,000 11,250 3,375 4 4 (45,000 – 11,250) 33,750 8,438 2,531 5 5 (33,750 – 8,438) 25,312
(b) If the asset is sold in Year 5, it is assumed for DCF purposes that a balancing charge or a balancing allowance will arise.
There is no annual capital allowance in the year of disposal.
If the asset is sold for more than its WDV at the beginning of the year of disposal, a balancing charge will arise. This increases taxable profits, and so increases the amount of tax payable (in the following year, since it is assumed that tax payments occur one year in arrear of profits).
If the asset is sold for less than its WDV at the beginning of the year of disposal, a balancing allowance will arise. This reduces taxable profits, and so reduces the amount of tax payable (in the following year).
In this example:
$ Sale value in Year 5 24,000 WDV at the start of the year 25,312 Balancing allowance 1,312
Since there is a balancing allowance of $1,312 for Year 5, there will be a tax saving of $1,312 × 30% = $394 in Year 6, one year in arrears. The effect of capital allowances on the cash flows of the project is therefore as follows:
Year
WDV at start of year
Capital allowance (25%)
Tax saved (30%) = cash flow benefit
Year of cash flow benefit
$ $ $
1 80,000 20,000 6,000 2
2 60,000 15,000 4,500 3
3 45,000 11,250 3,375 4
4 33,750 8,438 2,531 5
5 25,312
5 Disposal value (24,000)
5 Balancing allowance 1,312 394 6
The disposal value of the asset in Year 5, $24,000, is also a cash flow of the project.
Example
A company is considering an investment in a non-current asset (fixed asset) costing
£80,000. The project would generate the following cash profits:
Year £
1 30,000 2 40,000 3 20,000 4 10,000
The asset is eligible for capital allowances each year at 25%, by the reducing balance method. It is expected to have a residual value of £40,000 at the end of year 4. The after-tax cost of capital is 9%. The rate of tax on profits is 30%. Taxation cash flows
The first annual capital allowance can be claimed against the company’s profits for Year 1.
Required
Calculate the NPV of the project.
Answer
The balancing charge or balancing allowance?
The previous example shows that if the first annual capital allowance is claimed against Year 1 profits, the WDV of the asset at the beginning of year 4 (the year of disposal) will be £33,750. The disposal value of the asset at the end of year 4 is
£40,000. This means that there is a balancing charge in Year 4, because the disposal value is higher than the WDV.
Balancing charge = £40,000 - £33,750 = £6,250.
There will be extra tax payable in Year 5 for the balancing charge. Extra tax payment
= £6,250 × 30% = £1,875.
(If the residual value had been lower than £33,750, there would have been a balancing allowance and a saving in tax the following year).
Project cash flows and NPV Year Investment
Cash profits
Tax on profits at 30%
Tax-allowable dep’n – tax saved/ (extra tax)
Net cash flow
Disc factor
at 9% PV
£ £ £ £ £ £
0 (80,000) (80,000
) 1.000 (80,000)
1 30,000 30,000 0.917 27,510
2 40,000 (15,000) 6,000 31,000 0.842 26,102 3 20,000 (12,000) 4,500 12,500 0.772 9,650 4 40,000 10,000 (6,000) 3,375 47,375 0.708 33,542 5 (3,000) (1,875) (4,875) 0.650 (3,169)
NPV + 13,635