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Capital Rationing, Tax and Capital Allowances (An investment decision may…
Capital Rationing, Tax and Capital Allowances
An investment decision may be made on the basis of results from using all of the appraisal techniques
NPV
NPV takes priority, other techniques offer support to decision. Must be mindful of limitations of techniques.
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Capital Rationing
Soft Capital Rationing
Arises if managers
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Believe restricting available funds will encourage better investment projects (internal market for investment funds)
Single period Rationing
Firm must choose combination of projects to maximise total NPV, and maximise company value
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NPV should be considered relative to the size of the initial investment: NPV generated per capital invested.
Divisible projects can then be ranked using the profitability index (PI), resulting in more efficient use of funds.
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NPV Analysis requires assessment of cash flows, must prepare schedule of cash flows
Depreciation, Tax and capital allowances complicate the computation of cash flows and NPV
Depreciation is a non cash flow (substantial) so should be added back to profit to estimate actual cash flow
Capital Allowances are tax authority version of depreciation, to be applied in calculating taxable profit and tax charge
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After these adjustments, the regular NPV analysis is applied using the discount factor on net cash flows
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Limitations
As per all NPV calculations - assumption that profit and cash flow estimates for next four years are accurate
As per all NPV calculations - assumption that the discount factor is appropriate to the project, can be reliably calculated or estimated
Tax regimes are predictable or stable over life of project - capital allowances and corporate tax rates constant
Calculations assumed a constant corporation tax rate and a 25% reducing balance for capital allowances.
Alternative capital allowance treatments can apply E.g. a special asset class, first year allowances
Foreign investment projects can complicate tax affairs: liable to tax overseas with a balancing payment often due to UK