Learning Outcomes
After reading this article, you will be able to explain how inflation, taxation, and working capital influence project cash flows for investment appraisal. You will identify the adjustments needed for inflation, describe the treatment of tax in project calculations, and assess how changes in working capital affect investment project evaluations—key areas for ACCA FFM assessment.
ACCA Foundations in Financial Management (FFM) Syllabus
For ACCA Foundations in Financial Management (FFM), you are required to understand how real-world factors affect the measurement of project cash flows and risk. In particular, focus your revision on:
- How inflation alters the value of future project cash flows and the correct method to account for it in investment appraisal
- The impact of taxation on project-related cash flows, and how tax allowances, depreciation, and payment timing change project returns
- The treatment and calculation of working capital investments and recoveries within the project cash flow timeline
- The need to adjust discount rates and cash flows to reflect real versus nominal terms
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.
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When appraising a project, which aspect should be adjusted for inflation if costs and revenues are expected to increase at different rates?
- Discount rate only
- Project cash flows
- Asset life
- Tax rate
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How should working capital outflows and inflows typically be treated in project cash flow analysis?
- Ignore them
- Include both investment and recovery
- Only consider the initial investment
- Only include if they are financed by a loan
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True or false? Tax paid by a company always reduces project cash flows in the same year as profit is earned.
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Give one reason why the timing of tax payments can influence a project's net present value.
Introduction
Evaluating whether an investment project adds value to a business requires accurate estimates of cash flows over time. However, external factors like inflation, taxation, and changes in working capital often cause actual outcomes to differ from initial forecasts. Properly addressing these practical issues is essential for reliable investment appraisal.
This article introduces how inflation, tax rules, and working capital movements shape project cash flows, as required for the ACCA FFM exam. You will learn best-practice methods to adjust calculations and avoid common errors.
Key Term: inflation
The sustained general increase in prices over time, which reduces the purchasing power of money and affects future costs and revenues.
PROJECT CASH FLOWS AND INFLATION EFFECTS
Understanding Inflation Impacts
Inflation erodes the value of money over time. When estimating project cash flows, you must decide whether to use:
- Projected (nominal) cash flows: including specific annual price increase assumptions
- Constant (real) cash flows: expressed in current terms, ignoring future price rises
Your chosen discount rate must match your cash flow basis:
- If using nominal cash flows, discount at a money (nominal) rate that includes inflation
- If using real cash flows, use a real rate with inflation stripped out
Adjusting for Differential Inflation
Different project elements (e.g., revenues, maintenance, material costs) may inflate at varied rates. Forecast each major cash flow separately and apply the estimated inflation rate relevant to that item.
Worked Example 1.1
A company expects to invest $100,000 in equipment for a project generating $50,000 annual revenue for 4 years. Revenues will grow by 2% annually due to inflation. The appropriate nominal discount rate is 8%. Calculate the present value (PV) of future revenues.
Answer:
Step 1: Calculate projected revenue each year:
Year 1: $50,000
Year 2: $50,000 × 1.02 = $51,000
Year 3: $51,000 × 1.02 = $52,020
Year 4: $52,020 × 1.02 = $53,060
Step 2: Discount each amount at 8% nominal:
PV = $50,000/1.08 + $51,000/(1.08^2) + $52,020/(1.08^3) + $53,060/(1.08^4) Sum = $46,296 + $43,818 + $41,296 + $38,734 = $170,144 (rounded)
TAXATION AND PROJECT CASH FLOWS
Incorporating Tax in Appraisal
Most businesses are liable for corporate tax on profits. Calculations must recognize the impact of:
- Income tax payments (timing and amount)
- Depreciation or capital allowances, which reduce taxable profit
- Tax shields (reductions in cash outflow due to allowable deductions)
Key Term: capital allowances
Deductions permitted for tax purposes, based on a percentage of qualifying capital expenditure, which reduce taxable profit and therefore the tax paid.
Timing of Tax Payments
Tax is often paid in arrears; tax relating to a particular year's profit may be settled up to a year later. Adjust cash flow timing accordingly.
Worked Example 1.2
A project generates pre-tax cash inflows of $40,000 in each of 3 years. Tax is 25%, payable one year in arrears. Calculate net cash flows for each year.
Answer:
Year 1: $40,000 (tax on this paid in Year 2) Year 2: $40,000 (tax on this paid in Year 3) Year 3: $40,000 (tax on this paid in Year 4) Outflows (tax payments): Year 2, pay 25% × $40,000 = $10,000; Year 3, $10,000; Year 4, $10,000
WORKING CAPITAL IN PROJECTS
Working Capital Outflows and Recovery
Projects may need investment in inventories, receivables, or other current assets at start or during operation. Working capital invested is a cash outflow. At project end, most (or all) is assumed to be recovered—record as a cash inflow.
Key Term: working capital
The funds tied up in current assets (inventory, receivables, cash) minus current liabilities. For projects, it refers to additional short-term funding required to support activities.
Worked Example 1.3
A project has the following cash flows:
- Initial investment: $60,000 (equipment)
- Working capital: $10,000 at project start (outflow), fully recoverable at end of year 4 (inflow)
How should working capital appear in the project cash flow schedule?
Answer:
Year 0: Outflow of $60,000 (investment) and $10,000 (working capital) Year 4: Inflow of $10,000 (working capital recovered)
Exam Warning
Carefully distinguish between nominal and real cash flows when dealing with inflation. Do not mix real cash flows with a nominal discount rate or vice versa—this will often lead to incorrect project evaluations.
Summary
Sound project appraisal adjusts for inflation by matching nominal cash flows to the correct discount rate and allows for different rates across individual cash flow items. Tax effects are accounted for by including the reduction in cash flows due to tax payments and the impact of depreciation or capital allowances. Working capital requirements are cash outflows—assume their return at project completion. Careful attention to these adjustments is necessary for accurate investment assessment.
Key Point Checklist
This article has covered the following key knowledge points:
- How inflation alters project cash flow calculations and the importance of matching cash flow and discount rate assumptions
- The role of tax—including timing, capital allowances, and cash flow impacts—in investment appraisal
- The treatment of working capital as both an initial outflow and a terminal inflow in project schedules
- Common errors when incorporating inflation and tax into project appraisals
Key Terms and Concepts
- inflation
- capital allowances
- working capital