Effects of taxation on project appraisal

　　Investment in capital assets has taxation implications， which should be included in the analysis.To ignore the effect of taxation could affect the quality of the decision， which is consequently made about an investment opportunity. If the resulting project from the appraisal is profitable then taxation becomes payable on these profits thus reducing the net cash inflows by the amounts of tax payable. Capital allowances are given by the Inland Revenue at about 25% on a reducing balance basis over the life of the project. Capital allowances reduce the amount of tax which becomes payable. If the project has a terminal value at the end of its useful life， it will be necessary to establish whether this gives rise to a balancing allowance or a balancing charge. Net cash inflows are used in pay back，net present value and Internal rate of return methods. If the entity will not be in a tax-paying position during the entire life of the project then it is known as tax exhausted and tax can be ignored but this situation is most unlikely to occur.

　　Now that we have looked at these possible areas of complication let us look at a fictitious company we shall call Samco Plc.

　　Case

　　Samco Plc is a manufacturer of electric drills. The company has just developed two new models of electric drills. Model 1 is called Automatic and model 2 is called Super. Senior managers have resolved that if production were to commence in making the automatic model， 200，000 drills per annum will be produced and sold over the next five years at a price of ?200 per drill， whereas if production were to commence with the super model， 150，000 drills per annum will be sold over the next seven years at a price of ?140 per drill. Budgeted operating costs of each of the two models at today?s prices are as stated below：

　　Automatic model?

　　Direct material70

　　Direct Labour20

　　Variable overhead

　　Fixed production overhead

　　Selling， Distribution etc20

　　Net Cash inflow per unit =(?200 ? ?140)= ?60

　　Super model?

　　Direct material20

　　Direct labour12

　　Variable overhead15

　　Fixed production overhead

　　Selling， distribution， etc.

　　Net Cash inflow per unit =(?140 ? 70)= ?70

　　Net present value to infinity

　　Automatic model

　　NPV ?= NPV of the project/PV of annuity of appropriate years and rate

　　Discount Rate

　　= ?17，130，000/3.736

　　0.155

　　= ?29，581，405

　　Super model

　　= ?18，920，000/3.605

　　0.20

　　= ?26，241，332

　　Having calculated the net present values of the two projects to infinity clearly one can see that the automatic model has a net present value of about ?29.5m whereas super has a lower net present value of about ?26.2m. This means that the automatic model will give a higher return to the shareholders of Samco plc. This is the model the Board should manufacture and sell to their customers，because shareholders? wealth will be maximised by taking this course of action.

　　Conclusion

　　The main objective of this second article in the area of project appraisal was to demonstrate to readers that cases might not necessarily be straightforward. Aspects such as inflation， taxation and unequal life spans must be understood in order that candidates can competently answer questions requiring an understanding of these further aspects. The scenario in Samco plc should be carefully followed ensuring that you understand how the author has used the available information to answer the question.