Inflation refers to persistent increase in price of goods and services. It is also referred to as average general increases in the price of goods and services. Prior to this time, there had been lots of argument amongst writers in finance on whether or not to ignore or include inflation when computing capital budgeting. The argument has always being that inflation affects both the discount rate and the cash flow hence the effect will always cancel out.

During inflation shareholders will always demand for higher rate of return because inflation has a way of eroding the purchasing power of the shareholders but the impact of inflation on the company’s rate of return and the expected cash flow are not always the same. Shareholders are not likely to reflect the entire inflation rate on a single investment because of risk diversification strategy employed by most shareholders.

Besides, inflation will not affect all the cash flows in exactly the same

way. The impact of inflation on labour for instance will not be the same for material cost and cannot automatically reflect on selling price. Whichever way it is, the question is, How do we incorporate the effect of inflation in capital investment decisions? How do we adjust for inflation?

Will the project still be worthwhile after adjusting for inflation?

In analysing the effect of inflation in capital budgeting analysis two things should be taken into consideration. i. The effect of inflation on the discount rate – As inflation increases shareholders will demand for increased return to compensate for the reduction in the value of their capital. So there will be increase in the minimum return required by an investor. ii. How to take account of the impact of inflation on future cash flows.

There are basically two types of inflation:

i. General inflation – this is an increase in the average price of all goods and services in an economy. General inflation affects both the discount rate and the cash flow hence it should be properly estimated. Changes in consumer price indexes are used as a measure of general inflation in Nigeria. ii. Specific inflation – refers to changes in prices of the various components that make up the project under consideration. Various components such as sales prices, labour cost, variable cost etc. Specific inflation affects only the cash flows of the project. The treatment of specific inflation should be detailed as possible.

Money Cash flow and Real Cash flow In an inflationary period there is a difference between N10,000 cash and goods and services worth N10,000. The first is the money cash flow while the later is real cash flow.

Money Cash flow refers to the actual amount of cash flows in nominal term. To arrive at the money cash flow we adjust each item by its specific rate of inflation.

Real Cash flow on the other hand refers to purchasing power equivalent of the actual amount of cash flows. To arrive at the real cash flows we deflate (i.e. discount) money cash flows using the general rate of inflation.

In project appraisal, general inflation is usually assumed to be the same throughout the project’s life. It becomes easier to analyse the impact on both cash flows and the discount rate. However specific inflation rate need not be the same throughout the project’s life.

Money Cost of Capital (MCC) & Real Cost of Capital(RCC)

MCC – Measures the actual discount rate in terms of the actual money. That is, it is the discount rate in nominal terms. RCC – Measures the discount rate in constant price level terms. Return on an investment are usually based on expected returns. The anticipated rate of inflation will be reflected in required rate of return for a project. This relationship has long been recognised in financial economies and it is referred to as fisher’s effect. It is expressed as (1+m) =(1+r)(1+I) Where m= Money cost of capital

R= real cost of capital

I = General rate of inflation

From the equation above, if ‘r’ & ‘i’ are given, m could be computed as: M=(1+r)(1+i)-1

If m and I are given the r can be calculated as r = – 1

If m and r are given, then i can be calculated as follows i = – 1 Rules to follow using MCC & RCC 1. Cash flows in money or nominal terms should be discounted at money or nominal cost of capital 2. Cash flows stated in money terms can be converted to real cash flows by discounting at the general rate of inflation. The real cash flows should then be discounted at real cost of capital. 3. Discounting money cash flow at the money cost of capital and real cash flows at the real cost of capital will give the same NPV for a project. 4. The specific rate of inflation should be effected on specific cash flow only. The cash flow arrived at should then be discounted at the relevant cost of capital which in most cases is the money cost of capital except otherwise stated. 5. Money cash flows should be discounted with money cost of capital and real cash flow should be discounted with the real cost of capital.

Raze Ltd is considering a project costing N50,000. The project is expected to have a life of 4 years with a residual value of N4,000. Annual cash revenue from the project is expected to be N35,000 in year 1 rising by 6% per annum for inflation. Running cost are expected to be N15,000 in the first year of the project but would increase by 11% per annum because of inflating labour costs. The general rate of inflation is expected to be 8% and the company’s money cost of capital is 18%. Advice the company on whether or not to accept the project.

Rex Ltd have been considering a 5yrs project costing N3m which on an initial estimate would earn N1.1m per annum in contribution without incurring any additional fixed cost but with a nil residual value at the end of year 4. Cumulative discount rate at 15% for 5years is 3.352. The company’s director believes that the project should be undertaken because its NPV was N687,200.00 However, further investigation into the cash flow reveals the following. a. The contribution consists of annual sales of N2.7m and variable costs of N1.6m for 1million units of sales per annum.

These are the expected money values in year one. b. The sales would be made through a single distributor, who has asked for a fixed selling price of N2.70 per unit for 3yrs after which prices could increase by 18% for year 4 and held constant for year 5 c. Variable costs of N1.60 per unit in year one consists of material cost of N0.80 which are expected to increase by about 5% per annum and labour costs will rise by an expected 10% per annum for each year because of existing wage agreements with the trade unions concerned and a

shortage of skilled labour for the work.

Required

1. Is the initial NPV calculated correct

2. Is the project viable

Solution

Workings

Yr 1 2 3 45

Sales2,700,0002,700,0002,700,0003,186,000 3,186,000 Less

Material (800,000)(840,000)(882,000)(926,000) (972,405) Labour(800,000)(880,000)(968,000)(1,064,800) (1,171,280) Net MCF1,100,000980,000 850,0001,195,100 1,042,315

Labour at 10%

Material at 5%

Sales at 18% in years 4 & 5

Yr Cash flowsMCC @ 15%PV

0(3,000,000)1(3,000,000)

11,100,0000.8696956,560

2980,0000.7561740,978

3850,0000.6575558,875

41,195,1000.5718683,358

51,042,3150.4972518,239

The project is viable because it has a positive NPV of N458,010

The initial NPV calculated does not take into consideration the adjustment is sales, material and labour because of inflation.

Summary

We have looked at the impact of inflation in capital investment appraisal. Inflation refers to the persistent increases in prices of goods and services thus affecting the financing needs if the organisation as well as its cost of debt and WACC. Inflation is treated in capital investment appraisal by discounting inflated values of future cash flows at the money cost of capital or real cash flows at real cost of capital.

Review question

Idi araba town council plans to build a bridge over the local river to replace the existing ferry service. Building will start in one year’s time, that is 2006 and will take 4 yrs. It has planned to sub contract the building work to a major construction company and the best tender will involve the council in a cash expense of N10m at the start of building and further payments of N5m each year until 2010 once completed, the annual maintenance cost for the bridge will be N1m per annum according to today’s prices; the annual cost is expected to rise with the general inflation rate of 7% p.a. In addition, a major overhaul is expected to be required after the first 15years of use, this will comprise N10m of material plus wage costs of a further N10m in current prices.

Material prices are expected to rise with the general rate of inflation for the next 16years and then remain constant; wage cost is expected to increase by 6% over the general inflation rate for the next 3years and then increase in line with general prices. The market interest rate the council consider relevant for the whole life of the project is 17.7%. You can assume that for calculation purpose the life of the bridge is infinite. The expected use of the bridge is 20,000 vehicles per day and toll charge is expected to increase in line with general inflation.

Required

a. Calculate minimum toll charge in the first year of operation necessary for the bridge to break even over its life, and explain your treatment of inflation. Note: Assume all annual cash flows arise on the last day of the relevant year. b. What other factors do you think the council should consider when deciding upon the toll charge? Note: The statement that “in addition, a major overhaul is expected to be required after the first 15yrs of use” should be interpreted to mean at the end of the first 15years of use (i.e. year 20.5 +15) (ICAN , 1993)

Capital Investment Analysis and Taxation

Tax is an important factor to consider when computing capital investment appraisal because of its implications on cash flows. Capital investment appraisal is based on after tax incremental cash flows arising from the project. Thus, when appraising the viability of a project tax that has to be incorporated and then discounted at the relevant cost of capital.

Corporation tax

This is charged on the profit made on projects that is positive cash flows and then discounted at the appropriate ruling rate. Currently in Nigeria, it is charged at 30%. It is usually charged on a preceding year basis because tax is expected to be remitted 6-11 months after the end of the period in which profit were earned. In capital investment appraisal we assume a year lag for corporation tax payment, that is, tax on taxable profits made in year one will be deemed payable in year 2 except otherwise stated. Also, when losses are made on a project the losses are used to reduce tax liability hence, it is treated as tax benefit. The amount by which tax is reduced is equivalent to cash inflow to the project.

Investment Incentives – This is given to encourage investment in fixed assets. The main types include investment allowance and capital allowance.

Investment allowances – are receivables which should be brought into the project appraisal in the period in which they are receivable. They are use to reduce the tax liability.

Capital allowance- is available to reduce a tax liability if a business is carried on and it has a balance of qualifying capital expenditure. The reduction is treated as cash savings. Capital allowance could be treated on a straight line basis or a reducing balance basis. In Nigeria it is claimed as initial allowance and annual allowance. The Nigerian law permits a company to leave at least N10 in its book as written down value for an asset that is not yet disposed by the company. The Nigerian law also restricts the capital allowances a company can claim in any year of assessment to a certain percentage of the adjusted profit so that companies that have made profit can always increase their tax liability.

On disposal of an asset no capital allowance can be claimed in the year of disposal. When disposal is finally made, the difference between the proceeds on disposal and tax written down value treated as: i. A balancing charge – if the sales proceeds exceed the tax written down value. ii. A balancing allowance if the tax written down value exceeds the sales proceeds.

Assumptions on Investment allowance and capital allowance claims Two possible assumptions can be made on when to deduct capital allowance claims i. We can assume that the first claim is set – off on profits that occur in year one and it is deductible in year 1 ii. The most acceptable by examiners and in practice is to assume that the first claim occurs in year one and the tax savings occur one year later that is, year 2.

Illustration 1

A company purchases a machinery at a cost of N10,000 in respect of a project which has a life of 5years and a residual value of N500. Calculate the capital allowance on a straight line basis that will be used to reduce tax payment in each year of the project. The initial allowance is 50% while the annual allowance is charge at 25%.

Year ClaimsPoolAllowance

1. Initial allowance (50% x 10,000) 5,000 10,000

Annual allowance (25% x 10,000)

-5,000 -10) 1,247.50(6,247.5)6,247.5

2. written down value c/f3,752.5

Annual allowance(1,247.5)1,247.5

3. written down value c/f2,505

Annual allowance(1,247.50)1.247.5

4. written down value c/f1,257.5

Annual allowance(1.247.5)1.247.5

5. written down value c/f10

Sales proceed(500)

Balancing charge 490(490)

Illustration 2

XYZ company is considering investing in plant and machinery costing N100,000. The machine has a life of 5 years after which it can be sold for N5,000. The machine would generate annual cost of saving of N35,000. Investment incentive on the machinery will be available as follows: Investment allowance 20%, initial allowance 20%, annual allowance 10% on a straight line basis. Tax rate 35% payable one year in arrears and after tax cost of capital is 15%. Should the machine be purchased?

Solution

Workings

Investment allowance = 20% x 100,000 = N20,000

Capital allowance computation.

Year Claims Capital Tax written allowance N down value N

1 Initial allowance ( 20% x 100,000)20,000

Annual allowance(10% x 100,000)

– 20,000) 8,000 28,00072,000

2 8,00064,000

3 8,00056,000

4 8,00048,000

5 48,000 – 5000

Computation of tax liability

Year 1 2 3 4 5

Cost of savings35,00035,00035,00035,00035,000

Investment allowance(20,000)—-

Capital allowance(28,000)(8,000)(8,000)(8,000)(43,000) Taxable profits13,00027,00027,00027,0008,000

Tax at 35%4,550(9,450)(9,450)(9,450)2,800

Computation of NPV

Year Machinery Savings Tax Net cash DCF @15% PV 0 (N100,000)- – (N100,000)1 (N100,000) 1 35,000 – 35,0000.869630,436

2 35,000 4,550 39,5500.756129,903.76

3 35,000 (9,450) 25,5500.657516,799.13

4 35,000 (9,450) 25,5500.571814,609.49

5 50000 35,000 (9,450) 30,5500.497215,189.46 6 2,800 2,8000.43231,210.44

8,148.28

The NPV is positive and thus, the machinery should be purchased.

Illustration 3

New ventures Nigeria Ltd is considering a project with an initial cost of N5m. The project is to last for 5years with a scrap value of N10,000 .The project involves the production and sales of product X. Estimated future sales quantity and fixed costs are given below:

YearSales QtyFixed Costs

UnitsN,000

1100,0001,000

2110,0001,100

3120,0001,200

4120,0001,250

5125,0001,300

The selling price of product X is expected to be N50 per unit in year 1 rising by 5% per annum because of inflation. Variable costs are expected to be N25 per unit in year 1 rising by 8% per annum because of inflation. General level of inflation in the country is currently 7.5%. The company can claim capital allowance at the rate of 20% on the reducing balance basis on this project. Tax is currently at the rate of 35% payable one year in arrears. If the company’s after tax real cost of capital is 7%, should the company invest in the project?

Solution

Workings

Computation of cash profit

Year Sales Revenue Variable cost (N) Fixed CostProfits(N) 1100,000(N50)100,000(25)1,000,0001,500,000

2110,000(50)(1.05)110,000(25)(1.08)1,100,0001,705,000

3120,000(50)(1.05)2120,000(25)(1.08)21,200,0001,915,800 4120,000(50)(1.05)3120,000(25)(1.08)31,250,0001,916,614 5125,000(50)(1.05)4120,000(25)(1.08)41,300,0002,045,386

Computation of capital allowance(Reducing balance basis)

Year Capital allowance Written down value 120% x 5,000,0001,000,0004,000,000

220% x 4,000,000800,0003,200,000

320% x 3,200,000640,0002,560,000

420% x 2,560,000512,0002,048,000

52,048,000 – 10,0002,038,000-

Computation of tax liability

Year 12345

Profits1,500,0001,705,0001,915,8001,916,6142,045,386 Less cap allowance(1,000,000)(800,000)(640,000)(512,000) (2,038,000)

500,000905,0001,275,8001,404,6147,386

Tax @ 35% 175,000316,750446,530491,6152,585

Cost of capital to use:

(1+m) = (1+r)(1+i)

i+m = (1.07) (1.075)

M = 1.15025 – 1

M = 0.1503 x 100

M = 15.03%

Computation of NPV

Year Cost/Residual Cash profits Tax liability Net cash flow [email protected]% PV 0 (5,000,000) – -(5,000,000) 1 (5,000,000) 1 1,500,000-1,500,000 0.86931,303,900 21,705,000(175,000)1,530,000 0.75571,156.221 31,915,800(316,750)1,599,050 0.65701,050,576 41,916,614(446,530)1,470,084 0.5712839,712

5 10,0002,045,386(491,615)1,536,771 0.4965776,412 6(2,585) (2,585) 0.4317(1,116)

125,755

The company should embark on the project because it has positive NPV

Illustration 4

SCG limited is considering a project that has the following cash flow estimates

YearCash revenueCash Operating Expenses

1N’000N’000

21,600900

31,8001,100

41,400600

51,200500

500200

The project cost is N1.4m and has an estimated residual value of N10,500. The above cash flow profile has not taken into consideration the effect of changing prices. If effect on changing selling prices are taken into consideration cash revenue are expected to rise by 10% after year 1 and operating expenses by 11% after year 1. General level of inflation in the country is currently 15%.SCG Ltd can claim capital allowance at the rate of 25% on the reducing balance basis on this project. tax is currently at the rate of 35% payable one year in arrears. If the company’s after tax cost of capital is 20%,should the company invest in the project? Solution

Workings

Computation of cash profit

Year Cash revenue (N) Operating expenses(N) Profits(N) 11,600,000 900,000700,000

21,800,000(1.10) 1,100,000(1.11)759,000

31,400,000(1.10)2 600,000(1.11)2 954,740

41,200,000(1.10)3 500,000(1.11)3913,384.50

5 500,000(1.10)4 200,000(1.11)4428,435.92

Computation of capital allowance

Year Capital allowanceWritten down value

125% x 1,400,000350,0001,050,000

225% x 1,050,000262,500 787,500

325% x 787,500196,875 590,625

425% x 590,625147,656.25 442,968.75

5N442,968.75 – 10,500432,468.75

Computation of tax liability

12345

Profits 700,000 759,000 954,740 913,384.50 428,435.92 Less capital allowance 350,000 262,500 196,875 147,656.25 432,468.75 Taxable Profit 350,000 496,500 757,865 765,728.25 4032.83

Tax@ 35% (122,500) (173,775) (265,252.75) (268,005)

1,411.5

Computation of NPV

Year Cost/Residual Cash Profits Tax liability Net Cash flow [email protected]% PV 0 (N1,400,000) — (1,400,000)1 (N1,400,000) 1 700,000- 700,0000.8333583,310

2759,000(N,122,500) 636,5000.6944441,986

3954,740(173,775) 780,9650.5787451,944

4913,385(265,253) 648,1320.4823312,594

5 10,500428,436(268,005) 170,9310.4019 68,697 61,412 1,4120.3349 473

459,004

The company should embark on the project because it has a positive NPV Summary

The effect of taxation on a project will be to increase or reduce tax liability a company pays to the tax authority which will in turn increase or reduce the cash flows that will be used in arriving at the NPV of the project. When taxation is reflected in the cash flows, a post tax cost of capital should be used in evaluating the viability of the project.

Review questions

1. Turnaround Nig Ltd is considering an investment that requires an outlay of N100,000 to be spent on the acquisition of necessary plant and machinery. The investment is expected to last for a period of 5 years by which time the residual value of plant and machinery is expected to be N18,000.The net revenue is estimated at Period 12345

Net revenue 30,000 45,000 50,000 52,000 20,000

In addition, turnaround Nigeria Plc expensed an investment of N10,000 in working capital and advertising expenses of N2,000 in period 1 and period 2.

Turnaround Nigeria Plc has an after tax cost of capital of 10% and the application tax rate is 40% while the rates of capital allowance are initial allowance 20%,annual allowance 10%.Payment of tax claim may be assumed to be exactly one year in arrears.

Required:

Determine if the investment is worldwide

1. Links Ltd is considering investing in a project that will involve purchase of plant and machinery costing N150,000.The plant and machinery are expected to have a life span of 5 years and a residual value of N8,000. the project will generate cash profits as follows:

Capital allowance is available on the plant and machinery at the rate of 25% of cost on the reducing balance basis. Tax is currently payable at 35% payable one year in arrears. The company’s after tax cost of capital is 18%.advise if the project is worthwhile.