Project cash flows, tax, and inflation - Relevant cash flows...

Learning Outcomes

After reading this article, you will be able to identify and calculate relevant cash flows for project appraisals, correctly apply adjustments for taxation and inflation, and incorporate working capital movements into discounted cash flow calculations. You will understand which costs and benefits are relevant, how tax impacts project returns, and the correct treatment of working capital in investment appraisal for the ACCA FM exam.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand how to evaluate investment projects considering tax, inflation, and working capital effects. In particular, focus your revision on:

• Identifying and calculating relevant cash flows for investment projects
• Applying adjustments for tax, including tax-allowable depreciation and timing of tax cash flows
• Incorporating inflation in project appraisal using both real and nominal terms
• Including working capital investments and releases in cash flow schedules
• Laying out and interpreting full net present value (NPV) computations for projects

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. Which ONE of the following is a relevant cash flow when appraising a new investment project?
   1. Depreciation expense
   2. Increase in working capital
   3. Sunk research costs
   4. Allocated fixed overheads

2. Why is tax-allowable depreciation important in project appraisal?

3. When should a project’s initial investment in working capital be included as a cash flow?

4. A project’s costs and revenues are forecast in current prices. What adjustments are needed if inflation is expected?

Introduction

Project appraisal for the ACCA FM exam requires more than simple estimates of revenue and cost. You must be able to identify all relevant cash flows, consider the timing and impact of tax, make correct adjustments for inflation, and account for the effects of working capital. Each of these has a direct impact on the calculation of a project’s net present value (NPV) and therefore on investment decisions.

This article covers the rules for determining relevant project cash flows, the adjustments required for tax and inflation, and the correct treatment of working capital. Understanding these is essential for scoring well in Section C constructed response questions as well as in objective tests.

Key Term: relevant cash flow
A future, incremental, cash-based flow that will occur only if the project proceeds. Only these should be included in project appraisal.

Relevant Cash Flows for Project Appraisal

Only certain cash flows should be included in a project investment appraisal. Three key characteristics define a relevant cash flow:

• Future: Only cash flows that happen in the future as a result of undertaking the project.
• Incremental: Cash flows that arise directly from the project, not ones that will happen anyway.
• Cash-based: Only receipts and payments of cash; non-cash items are excluded.

Irrelevant Costs and Revenues

These should be ignored in project appraisal:

• Sunk costs: Costs already incurred, such as past research or market studies.
• Allocated or absorbed overheads: Overhead charges that do not increase because of the project.
• Non-cash items: Depreciation is not a cash flow; only relevant for its tax impact.

Key Term: sunk cost
A cost already incurred and irrecoverable. It is NOT relevant to current investment decisions.

Key Term: tax-allowable depreciation
A deduction for tax purposes, reducing taxable profit by a specified percentage or amount based on capital expenditure.

Key Term: working capital
The net investment in current assets (inventory, receivables, cash) less current liabilities, required to support project operations.

Worked Example 1.1

A company is considering a project requiring new machinery costing $200,000. An $8,000 feasibility study was conducted last year. Overheads will be allocated at $12,000 per year, although only $3,000 will be incurred because of the project. The machine will be depreciated for accounting at $40,000/year. What costs are relevant to the project?

Answer:

• Relevant outflow: $200,000 for machinery (future, incremental, cash outflow).
• Sunk cost: $8,000 study—already spent, not relevant.
• Only the incremental overhead: $3,000/year is relevant, not the $12,000 allocation.
• Depreciation: Not a cash flow; only include its effect on tax if relevant.

Exam Warning

Do not include depreciation or sunk costs in your DCF cash flows unless specifically required for tax calculations.

Accounting for Tax in Project Cash Flows

Tax has a significant impact on project returns and must be correctly incorporated into your appraisal.

• Operating cash flows: Revenue less allowable cash expenses, taxed at the corporation tax rate.
• Timing: Tax is usually paid one year after the related cash flow, unless stated otherwise.
• Tax-allowable depreciation: Most tax authorities provide a tax deduction for capital expenditure (e.g., ‘writing-down allowances’ or straight-line). This reduces taxable profit and therefore tax paid, usually claimed as soon as possible.
• Balancing allowance/charge: On asset disposal, any remaining unclaimed (or excess claimed) value is balanced as an extra deduction or additional taxable amount.

The tax effect on cash flows must reflect both operational tax and the cash impact of tax-allowable depreciation.

Worked Example 1.2

A project requires an initial outlay of $120,000 on plant. Tax is 25%, paid one year in arrears. Tax-allowable depreciation is 20% reducing balance annually. The plant has no scrap value after five years. What is the present value of the total tax savings from capital allowances? (Assume 10% discount rate.)

Answer:

• Year 1: WDA = 20% × $120,000 = $24,000; tax saving next year = 25% × $24,000 = $6,000
• Year 2: WDA = 20% × $96,000 = $19,200; tax saving next year = $4,800
• Continue for 5 years.
• Each year’s tax saving is discounted using the one-year lag.
• Include a balancing allowance in the final year for any remaining value.

Allowing for Inflation

Investment cash flows can be presented in either current (real) or expected (money/nominal) terms. When inflation is significant, it must be included in appraisal.

• Money (nominal) terms: Cash flows are increased year-by-year for expected inflation. Discount at the money cost of capital (includes inflation).
• Real terms: Cash flows remain at current price levels. Discount at the real cost of capital (excludes inflation).

Consistency is essential: match cash flows with the correct discount rate.

Key Term: real terms
Amounts measured by today’s price level—no inflation adjustment.

Key Term: money (nominal) terms
Amounts measured in the actual currency expected to be received or paid in the future, including inflation.

Dealing with Multiple Inflation Rates

If items in your project (e.g., sales, costs, and wages) inflate at different rates, you must inflate each separately to determine money cash flows and then discount using the money rate.

Worked Example 1.3

A project has the following current price forecasts:

• Revenues: $150,000/year
• Materials: $60,000/year, expected to inflate at 8% p.a.
• Wages: $40,000/year, expected to inflate at 3% p.a. If general inflation is 4% and the real cost of capital is 7%, explain how to prepare your cash flows.

Answer:

• Inflate materials and wages at their specific rates for each year.
• Inflate revenue at the general rate unless otherwise stated.
• Sum to get annual nominal cash flows.
• Calculate the money cost of capital using Fisher’s formula: (1 + i) = (1 + r)(1 + h) ⇒ (1 + i) = (1.07) × (1.04) = 1.1128, so i ≈ 11.3%
• Discount the nominal cash flows at 11.3%.

Working Capital Flows in Appraisal

Projects often require an increase in working capital (e.g., more inventory or receivables) at the outset. This increase is a cash outflow. At project end, working capital is released as a cash inflow.

• Working capital investment is usually required at the start and may change over the project's life as sales or operations grow.
• Any incremental increases during the project life are additional outflows.
• All working capital invested is typically assumed to be recovered as an inflow in the final year.
• When inflating project cash flows, calculate working capital requirements on the inflated (money terms) values.

Worked Example 1.4

A project plans sales (in money terms) of $400,000 in Year 1, $440,000 in Year 2, and $484,000 in Year 3. The company’s policy is to invest in working capital equal to 12% of annual sales, with the required amount in place at the start of each year. The project ends after Year 3. Calculate the cash flows relating to working capital for appraisal.

Answer:

• At start of Y1: Outflow = 12% × $400,000 = $48,000
• At start of Y2: Required = 12% × $440,000 = $52,800; incremental outflow = $4,800
• At start of Y3: Required = 12% × $484,000 = $58,080; incremental outflow = $5,280
• At end of Y3: Entire $58,080 is released as a cash inflow.

Laying Out the Project Appraisal Calculation

A full project cash flow schedule should include:

• Initial investment (capital expenditure)
• Incremental working capital investments and releases
• Operating cash flows (incremental receipts less expenses)
• Tax payments (and reliefs from tax-allowable depreciation), with any timing delays applied
• Disposal/scrap proceeds (after-tax, if relevant)

Set out each item by year, inflate appropriately, and discount at the correct rate.

Revision Tip

Always show working capital inflows and outflows as separate lines in your NPV calculation. This makes both the schedule and NPV workings clear for exam markers.

Summary

Success in ACCA exam project appraisals depends on accurately identifying future, incremental, cash-based project flows, adjusting all items for tax and inflation as required, and remembering both working capital investments and releases. Consistent and complete schedules are essential to maximize marks.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and identify relevant cash flows for project appraisal
• Exclude sunk, allocated, and non-cash items from appraisal calculations
• Calculate the impact of tax and tax-allowable depreciation on project cash flows
• Accurately apply inflation adjustments and select the correct discount rate for real or nominal terms
• Incorporate incremental working capital investments and inflows into NPV calculations

Key Terms and Concepts

• relevant cash flow
• sunk cost
• tax-allowable depreciation
• working capital
• real terms
• money (nominal) terms