Lecture on Discounted Cash Flow and Taxation

Introduction

• Focus on Chapter 8 from the Open Tuition free lecture notes.
• Discusses relevant cash flows in discounted cash flow projects.
• Last lecture covered working capital; this lecture covers tax.

Importance of Tax in DCF

• Tax is almost always relevant in DCF calculations for new projects.
• Increased earnings from projects lead to increased company profits and thus increased tax liabilities.
• Tax is a cash flow that must be incorporated into DCF analysis.

Understanding Tax Basics

• Limited tax knowledge is needed, sufficient for the context of F9 exams.
• Familiarity with tax rules from earlier studies (e.g., F6) is beneficial.

Example Illustration

• Scenario: Company purchasing a new machine for $10,000, with projected net operating cash flows.
  • Year 1: $5,000
  • Year 2: $7,000
  • Year 3: $8,000
  • Sale at end of Year 3 for $6,000
  • Additional working capital needed: $1,000
• Tax Rate: 30% payable one year in arrears.
• Capital Allowances: 25% on a reducing balance basis.

Calculating Cash Flows and Tax

• Net Operating Cash Flow: Calculate tax based on net operating cash flow, considering tax allowable depreciation (capital allowances).
• Tax Calculation:
  • Example: Tax on $1,000 operating cash flow with $200 capital allowances.
  • Tax = 30% on taxable profit after allowances.
  • Cash Flows: Inflow of $1,000 minus tax outflow.

Efficient Tax Calculation Method

• Simplified method for exams involves:
  • Calculating net operating cash flows.
  • Separately calculating tax savings from capital allowances.

Example 4 Detailed Calculation

• Establish project duration from machine sale (3 years) and set up yearly columns.
• Operating Flows:
  • Year 1: $5,000
  • Year 2: $7,000
  • Year 3: $8,000
• Tax Calculation:
  • Year 1: $1,500 (payable one year later)
  • Year 2: $2,100
  • Year 3: $2,400

Capital Flows and Tax Savings on Capital Allowances

• Initial Cost: $10,000
• Sale Proceeds: $6,000 in Year 3
• Capital Allowances Calculation:
  • Year 1: $2,500
  • Year 2: $1,875
  • Balancing charge or allowance in Year 3

Working Capital and Cash Flow Analysis

• Initial working capital of $1,000 needed.
• Return of working capital assumed at project end.
• Net Cash Flows Calculation:
  • Year 0: Outflow of $11,000
  • Year 1: Inflow of $5,000
  • Year 2: Inflow after tax and savings
  • Year 3: Inflow after tax and savings
  • Year 4: Outflow due to balancing charge

Discount Calculation

• Discount factor applied at 10% cost of capital.
• Calculate present values for each year.

Conclusion on Project Viability

• NPV Calculation: Positive net present value ($6,877)
  • Decision: Accept the project due to positive NPV.

Exam Tips

• Each calculation step is marked separately; show clear workings.
• Manage tax calculations for clarity and efficiency.
• Do not worry about tax losses; assume overall company profitability.
• Inflation will be covered in the next lecture.