## **Learning Outcomes**

After reading this article, you will be able to determine and adjust project cash flows for taxation, inflation, and working capital in discounted cash flow (DCF) investment appraisal. You will understand how to model tax relief, deal with multiple inflation rates, and calculate incremental working capital movements. You will also know how these elements impact the net present value (NPV) and internal rate of return (IRR) of a project, and apply these adjustments under exam conditions.

## **ACCA Advanced Financial Management (AFM) Syllabus**

For ACCA Advanced Financial Management (AFM), you are required to understand the practical application of DCF techniques. This article focuses on the following syllabus areas:

- Evaluate a project's NPV and IRR with explicit adjustments for inflation, tax (including allowances), and working capital.
- Determine the appropriate treatment of specific and general inflation in cash flows and discount rates.
- Calculate and model the impact of corporation tax, including tax-allowable depreciation.
- Assess and incorporate incremental working capital requirements in project appraisal.
- Apply appropriate financial techniques under exam scenarios that include the above practical complications.

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Why is it usually incorrect to discount real (inflation-free) cash flows at a money (nominal) discount rate when appraising projects under inflation?
2. List three types of cash flows that may require adjustment for corporation tax in NPV calculations.
3. Explain how incremental working capital should be treated in a DCF appraisal, including its reversal.
4. A project requires a \$10m investment at time 0. The company pays corporation tax at 25% and receives tax-allowable depreciation at 20% reducing balance per annum. Briefly outline the tax adjustments required in years 1-5.
5. True or false? Tax relief for capital allowances should be included when calculating taxable profits for project appraisal purposes.

## **Introduction**

DCF investment appraisal is a core method for evaluating capital projects, with NPV and IRR as standard techniques. In practice, several real-world complications arise: inflation often affects costs and revenues at different rates, taxation impacts both operating and capital cash flows, and projects typically create incremental working capital needs. Each of these factors must be handled correctly in cash flow projections to ensure decision-making is robust and shareholder wealth is maximized.

> **Key Term: discounted cash flow (DCF) technique**
> A financial appraisal method where future net cash flows are discounted to their present value at a specified discount rate to determine project acceptability.

## **Tax Adjustments in DCF Appraisal**

Corporate tax affects both operating and non-operating cash flows. Tax is charged on taxable profits, typically calculated as operating inflows less allowable expenses. Importantly, tax-allowable depreciation (often called capital allowances) provides tax relief but is a notional expense for appraisal purposes.

> **Key Term: tax-allowable depreciation**
> The notional amount of asset depreciation that is permitted by tax authorities to be deducted when calculating taxable profits, generating tax relief for the business.

Corporation tax on project profits is usually paid on an annual basis, but payment may be lagged (e.g., one year after the profit is earned). For initial investment, tax relief is given over several years according to the capital allowance schedule. Any remaining asset value may trigger a balancing allowance or charge on disposal.

### **Worked Example 1.1**

A company invests \$20,000 in equipment (no scrap value), writes off the investment at 25% reducing balance per year, and earns net operating inflows of \$7,500 per year for four years. Tax at 30% is paid one year in arrears.

**Required:** Calculate taxable profits and tax paid for each of the four years.

> **Answer:**
> For each year, taxable profit equals operating inflow minus that year’s tax-allowable depreciation. Tax is paid one year after each profit is earned. At the end, any unrelieved investment triggers a balancing allowance.

### **Exam Warning**

> Tax timing is a frequent source of error. If tax is paid in arrears, ensure that all tax cash flows are correctly shifted by one year in your NPV calculation.

## **Inflation Adjustments in DCF Appraisal**

Inflation affects investment appraisal in two main ways. Firstly, cash flows such as revenues and different cost categories may inflate at distinct rates (specific inflation). Secondly, discount rates (cost of capital) may be expressed either in real terms or money (nominal) terms.

> **Key Term: nominal (money) rate**
> The discount rate that includes the effect of general inflation, used to discount cash flows expressed in money terms.
>
> **Key Term: real rate**
> The discount rate that excludes inflation, used to discount cash flows expressed in constant price terms.

If specific inflation rates apply to individual cash flows, forecast each stream in money terms, then discount at the nominal rate. Alternatively, if all flows inflate at the same general rate, real cash flows can be discounted at the real rate.

> **Key Term: Fisher formula**
> The mathematical relationship between real and nominal rates:  
> $$(1 + i) = (1 + r)(1 + h)$$
> where $i$ = nominal rate, $r$ = real rate, $h$ = inflation rate.

### **Worked Example 1.2**

Projected sales income is \$1m in the current year, inflating at 6% annually for five years. The company’s real cost of capital is 8%. Calculate the present value of the sales receipts using both (a) real and (b) nominal approaches if general inflation is 6% per year.

> **Answer:**
> (a) Use \$1m per year at an 8% real discount rate.  
> (b) Inflate \$1m by 6% each year to get money values, then discount at the nominal rate computed using the Fisher formula:  
> $$(1 + i) = (1 + 0.08)(1 + 0.06) = 1.145$$
> so $i = 14.5\%$.

### **Revision Tip**

> Always match the inflation status of your cash flows and discount rate. Do not mix real cash flows with a nominal rate or vice versa.

## **Working Capital Adjustments in DCF Appraisal**

Many projects need additional working capital (e.g., inventory, receivables) as sales grow. In DCF analysis, only incremental changes in working capital are included.

> **Key Term: incremental working capital**
> The additional net investment in current assets (less current liabilities) required by a project, released at the end of the project’s life.

At each period, forecast the total working capital required (often as a percentage of the following year’s inflating revenue or costs), then deduct the previous balance to find the incremental amount. The full working capital investment is assumed to be recovered as a cash inflow at the end of the project.

### **Worked Example 1.3**

A project generates increasing sales of \$2m, \$2.6m, \$3.1m, and \$3.3m in years 1–4. Working capital required at the start of each year is 10% of that year’s sales. Calculate working capital injections or releases for investment appraisal.

> **Answer:**
> At the start of year 1: \$2m × 10\% = \$0.2m  
> Start year 2: \$2.6m × 10\% = \$0.26m (\$0.06m increase from year 1)  
> Start year 3: \$0.31m  
> Start year 4: \$0.33m  
> At project close (end of year 4), the full \$0.33m is released back.

### **Exam Warning – Working Capital**

> If inflation causes revenues to rise over time, remember to calculate working capital requirements on inflated future figures.

## **Bringing It All Together in Project Appraisal**

In DCF appraisal, always:

1. Forecast revenues and costs, adjusting for specific inflation rates.
2. Calculate operating profit, adjust for capital allowances, and assess taxable profits.
3. Deduct tax, following the correct timing.
4. Include incremental working capital movements, inflating as required.
5. Discount all project cash flows at a nominal (money) cost of capital, if cash flows are in money terms.

### **Worked Example 1.4**

A company invests \$3.5m, expects real annual net cash inflows of \$1m for four years, inflating at 4% annually. The company’s real cost of capital is 6%; tax at 20% is paid on profits lagged by one year. Asset qualifies for tax-allowable depreciation at 25% reducing balance; no residual value. Additional working capital is required at 12% of inflated revenues yearly and is fully released at project close.

**Required:** Outline calculation steps for the NPV.

> **Answer:**
>
> 1. Inflate \$1m by 4% annually to get money cash flows.
> 2. Calculate annual tax-allowable depreciation on remaining asset value.
> 3. Derive taxable profits and lagged tax payments.
> 4. Calculate working capital required at the start of each period on inflated revenue.
> 5. Discount all adjusted cash flows at the nominal cost of capital ($i = (1.06)(1.04) - 1 ≈ 10.24\%$), sum to obtain NPV.

## **Summary**

DCF appraisals must reflect tax, inflation, and working capital accurately for dependable results. Adjust cash flows for project-specific inflation, determine tax effects (including capital allowances and their timing), and model working capital injections and releases based on project needs and inflation. The correct application of these adjustments ensures NPV and IRR are calculated on a like-for-like basis, enabling valid investment decisions.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Identify and incorporate tax effects in project investment cash flows, including capital allowances.
- Adjust for both specific and general inflation when forecasting future cash flows.
- Correctly match cash flow inflation treatment to the discount rate (real or nominal).
- Calculate and model incremental working capital movements, ensuring proper treatment at project close.
- Recognize the impact of tax timing differences in NPV and IRR computations.
- Apply the Fisher formula to link real and nominal discount rates.

## **Key Terms and Concepts**

- discounted cash flow (DCF) technique
- tax-allowable depreciation
- nominal (money) rate
- real rate
- Fisher formula
- incremental working capital

DCF techniques and practical complications - Tax, inflation, and working capital adjustments