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Impact of Inflation and Tax on Project Appraisal - Coggle Diagram
Impact of Inflation and Tax on Project Appraisal
Impact of inflation on interest or discount rates
Inflation is a general increase in the money price of goods and services leading up to a general decline in the real value or the purchasing power of money
In times of inflation lenders will require a return made up of two elements
A real return to compensate for the use of their funds (the expected return with no inflation in the economy)
An additional return to compensate for their lost purchasing power from inflation
The overall required return is called the money, nominal or market rate of return
Real interest rate = nominal interest rate - inflation rate
The impact of inflation on cash flow
Cash flows at current prices do not account for expected inflation
The expected cash flows that are increased to account for inflation are referred to as money cash flows and represent expected flows of money and are normally assumed to be the money cash flows
Inflation affects both the estimated cash flows and the discount rate
Inflation is incorporated into NPV calculations using one of the following methods
Using nominal future cash flows that incorporate expected inflation by building in expected price increases by building increases and discounting using the nominal discount rate. This is the better method for taking into account price increases
Using real cash flows that are expressed at today's price level and discounting using the real discount rate (the cost of capital after removing the rate of general inflation). It is assumed that the future price changes will be the same as the general rate of inflation
Tax effects
Corporate tax is charged on taxable profits for most companies
Tax must be considered in any investment appraisal
The impact of taxation on cash flows is felt in different ways but the most common impacts for NPV purposes include
Tax charges on profit figures
Tax relief for an acquired asset in the form of capital allowance or writing down allowances
Tax relief on the sale or disposal of an asset at the end of the project
Tax is normally payable one year in arrears, it is therefor included in NPV calculations with a one year delay, the discount rate can be either pre or post tax
The tax effect is incorporated into the overall discount rate by adjusting for the tax relief on interest paid on the cost of debt
Writing down allowances
Companies can also benefit from writing down allowances
This tax relief is an alternative to depreciation deductions from accounting profit
It provides a tax benefit by reducing the amount of tax payable
Writing down allowances are calculated on the written down value of the assets
They are claimed as early as possible in the assets life and are claimed annually until the total allowances equate the cost less any scrap proceeds
A further balancing allowance arises in the year of disposal or scrapping if the disposal proceeds are lower than the tax written down value
A balance charge can arise if the disposal proceeds are greater than the tax written down value
Capital rationing and use of the profitability index
Shareholder wealth is maximised if a company undertakes all positive NPV projects
When there are insufficient funds to do so, investment capital is rationed or limited
Capital rationing is a strategy implemented when a company has more acceptable projects then can be financed from existing funds
Hard capital rationing
When lending institutions impose an absolute limit on the amount of finance available
The reasons may include
industry wide factors limiting funds
Company specific factors like a poor track record, lack of asset security or poor management limiting funds
Soft capital rationing
When a company voluntarily imposes restrictions that limit the amount of funds available for investment in projects
Reasons may include
Internal company policies
Limited management skills for handling multiple financing options
The desire to maximise return on a limited range of investments
Limiting exposure to external finance
Focusing on existing substantial profitable businesses or divisons
Dealing with single period capital rationing using the profitability index
Divisble projects
Projects are considered to be divisible when any fraction of the project can be undertaken
The returns from the project should be generated in exact proportion to the amount of investment undertaken
The profitability index or benefit-cost ratio can be used for dealing with divisible projects or comparing individual projects
The profitability index calculates the present value of cash flows generated by the project per a unit of capital outlay
It can provide a solution when the company cannot undertake all acceptable projects due to limited budgets
PI = NPV / original cost of investment or initial cash outflows
Decision rules
When there are alternative projects, rank the projects according to PI and allocate funds according to the projects rankings