(2)
Example, suppose tax-allowable depreciation is allowed on the cost of
plant and
machinery
at the rate of 25% on a
reducing balance
basis. Thus if a company purchases
plant costing $80,000, the subsequent writing down allowances would be as follows:
Year
Tax-allowable depreciation ($)
Reducing balance ($)
1
2
3
4
(3)
When the plant is eventually sold, the difference between the sale price and the reducing
balance amount at the time of sale will be treated as:
(a)
a taxable profit if the sale price exceeds the reducing balance, and
(b)
as a tax allowable loss if the reducing balance exceeds the sale price.
(4)
The cash saving on tax-allowable depreciation (or the cash payment for the charge) is
calculated by multiplying the depreciation by the tax rate.
(5)
There are two possible assumptions about the time when tax-allowable depreciation starts
to be claimed.
(a)
It can be assumed that the first claim occurs at the start of the project (at year 0)
(b)
Alternatively it can be assumed that the first claim occurs later in the first year

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IPK COLLEGE
1664, JALAN KULIM, 14202 BUKIT MERTAJAM, PENANG
TEL : 012-5203212 / 0125113212 / 04-5512588
Subject: Financial Management
(DFM1)
Prepared by Susan Lim
Email : [email protected]
Example: Taxation
A company is considering whether or not to purchase an item of machinery costing $40,000
payable immediately. It would have a life of four years, after which it would be sold for $5,000.
The machinery would create annual cost savings of $14,000.
The company pays tax one year in arrears at an annual rate of 30% and can claim tax-allowable
depreciation on a 25% reducing balance basis. A balancing allowance is claimed in the final
year of operation. The company's cost of capital is 8%.
Should the machinery be purchased?
Exercise
A company is considering the purchase of an item of equipment, which would earn profits
before tax of $25,000 a year. Depreciation charges would be $20,000 a year for six years. Tax-
allowable depreciation would be $30,000 a year for the first four years. Tax is at 30%.
What would be the annual net cash inflows of the project:
(a) For the first four years
(b) For the fifth and sixth years
assuming that tax payments occur in the same year as the profits giving rise to them, and there
is no balancing charge or allowance when the machine is scrapped at the end of the sixth year?
NPV Layout
When answering an NPV question, you may find it helpful to use the following layout. The
most important thing to notice is that tax on cash profits and cash flows arising from tax-
allowable depreciation can be calculated and presented separately. There is no need to combine
them into a single cash flow figure for tax.

___________________________________________________________________________________________________________________
Page
8
of
13
IPK COLLEGE
1664, JALAN KULIM, 14202 BUKIT MERTAJAM, PENANG
TEL : 012-5203212 / 0125113212 / 04-5512588
Subject: Financial Management
(DFM1)
Prepared by Susan Lim
Email : [email protected]
Year
0
1
2
3
4
Sales receipts
X
X
X
Costs
(X)
(X)
(X)
Sales less costs
X
X
X
Taxation on profits
(X)
(X)
(X)
(X)
Capital expenditure
(X)
Scrap value
X
Working capital
(X)
X
Tax benefit of tax depreciation
X
X
X
X
(X)
X
X
X
(X)
Discount factors
X
X
X
X
X
PV
(X)
X
X
X
(X)
Working capital and inflation
We saw how to calculate working capital cash flows in Chapter 4. This calculation is
complicated when inflation is also to be considered.

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- Spring '17
- JANE KDAL