Company tax in an appraisal, and the relief that reverses the answer

CB1 · Business Finance · 10 min read

1Why tax belongs in the appraisal and not after it

A shareholder receives money the company has paid tax on. So the cash flows that matter in an appraisal are after-tax cash flows, and a project evaluated before tax is being evaluated on money nobody will ever receive.

That much is obvious. What is not obvious, and what this page is for, is that tax does not scale a project down by a fixed proportion. It has its own rules about what is deductible and its own timing, and both can change a decision rather than just a number.

2The first rule: taxable profit is not accounting profit

A company computes profit under accounting rules and tax under tax rules, and the two never quite agree. For an appraisal, one difference does most of the work.

Depreciation, as the accountant charges it, is not allowed as a deduction for tax. In its place the tax rules give a capital allowance on qualifying assets — their own schedule, at their own rate, on their own basis.

So the sequence for every year of a project is three steps, and they must be kept apart:

One. Take the operating cash flow, which already excludes depreciation because depreciation is not cash.

Two. Deduct the capital allowance to get taxable profit, and compute the tax on that.

Three. Subtract the tax from the operating cash flow. Do not subtract the allowance — it was never a cash flow. It only reduced the tax.

Step three is where marks are lost. The allowance appears in the tax computation and nowhere else.

3The mechanism: the allowance is a stream of tax savings, and it has a value

Here is the idea that makes the topic tractable. A capital allowance of A in a year, at a tax rate of t, reduces the tax bill by exactly A × t. That saving is cash, it arrives on a known date, and it can be discounted like anything else.

So the whole project splits cleanly in two, and both halves can be valued separately:

The trading half. Operating cash taxed at the full rate, as though no allowance existed.

The shield. The present value of the tax saved by the allowances.

Add them and you get the same answer as the year-by-year table, which is the cross-check in the worked example. The reason to bother is that the split tells you where the value is. In the example below the allowance shield is worth ₹79 lakh on a ₹400 lakh machine, and the project is worth ₹36 lakh — so the shield is not a detail that improves the answer, it is the entire reason there is an answer.

That is a general lesson rather than a feature of invented numbers. For a capital-intensive project with a thin trading margin, the tax treatment of the asset can be worth more than the trading.

4The second rule: when the tax is paid

Tax on a year's profit is not always paid in that year. Where it is paid a year later, every tax outflow moves one year further away and is discounted one more time, which makes the project more valuable — not because less tax is paid, but because it is paid later.

The size of the gain is the discount for one year on the whole tax stream, and it is worth computing rather than describing. The worked example does it and finds ₹3.60 lakh, which is 10% of one year's deferred tax bill discounted over the project. A question that specifies the timing is specifically testing this, and a question that does not should be answered with the assumption stated.

5The third rule: interest relief belongs in the discount rate

Interest is deductible, so borrowing carries a tax saving. This is the (1 − t) in the weighted average cost of capital, and it is the reason the cost of debt in that formula is lower than the rate the lender charges.

Which means it is already counted once you discount at the WACC. Deduct interest from the project's cash flows as well and you have charged the company twice for the same borrowing — a double count that makes bad projects look good and is one of the easiest errors to make in this part of the syllabus.

The rule to hold on to: the project's cash flows are the project's. How it was financed lives in the discount rate. The only tax that belongs in the cash flows is tax on the operating result, adjusted for allowances.

6What else moves the answer

A loss-making year. The relief is only worth something if there is profit to set it against. A company with no taxable profit this year carries the loss forward, which delays the benefit and so reduces its present value. Assuming immediate relief in a company that cannot use it overstates the project.

A balancing adjustment at the end. If the written-down value for tax differs from the sale proceeds when the asset goes, the difference is taxed or relieved in the final year. It is a real cash flow and it is routinely forgotten.

A change in the rate. An appraisal runs for years and tax rates change. The honest treatment is to use the announced rates where they are known, state the assumption for the years beyond, and test how much the conclusion depends on it.

A worked example

An invented example, built for this page. A packaging machine for a plant in Aurangabad. Every figure is made up, and the tax rules below are a simplified set chosen to keep the arithmetic exact — they are not a statement of any country's actual tax code.

The four-year annuity factor at 10% is the sum of the four discount factors:

Because the cash flow is the same every year, every present value below is a single multiplication by that factor.

1. 1Route 1: the year-by-year table

   Each year is identical, so one column does the work of four.

   Line	Working	Each year
   Operating cash inflow	given	₹150.00 lakh
   Less capital allowance	400 ÷ 4	(₹100.00 lakh)
   Taxable profit	150 − 100	₹50.00 lakh
   Tax at 25%	25% × 50	₹12.50 lakh
   After-tax cash flow	150 − 12.50	₹137.50 lakh

   Note which line the allowance appears on and which it does not. It reduced the taxable profit; it never left the after-tax cash flow, because it was never cash.

   PV = 137.50 × 3.169865 = ₹435.86 lakh
   NPV = 435.86 − 400 = +₹35.86 lakh

2. 2Route 2: trading half plus the shield

   Now value the same project in two pieces, each from the printed assumptions.

   The trading half — operating cash taxed at the full rate, as if there were no allowance:

   150 × (1 − 0.25) = ₹112.50 lakh a year  →  112.50 × 3.169865 = ₹356.61 lakh

   The allowance shield — the tax saved by the ₹100 lakh allowance:

   100 × 0.25 = ₹25.00 lakh a year  →  25.00 × 3.169865 = ₹79.25 lakh

   Add the two present values, using the figures just printed:

   356.61 + 79.25 = ₹435.86 lakh

   which is Route 1's present value exactly, so NPV = +₹35.86 lakh again. The two routes agree, and the second one has told us something the first could not.

3. 3What the shield is actually doing

   Take the allowance away and keep everything else, which is Route 2's trading half on its own:

   NPV without any allowance = 356.61 − 400 = −₹43.39 lakh

   The project fails. Put the shield back:

   −43.39 + 79.25 = +₹35.86 lakh

   The same ₹35.86 lakh as both routes above, and the arithmetic chains from the printed figures. So on this machine the capital allowance is not a refinement of the answer — it is the answer. A board told only "the project returns 10% on its money" would have no idea that the entire case rests on a tax rule.

4. 4And what the tax costs in total

   For completeness, value the project as if there were no tax at all:

   150 × 3.169865 = ₹475.48 lakh  →  NPV = 475.48 − 400 = +₹75.48 lakh

   So tax costs 75.48 − 35.86 = ₹39.62 lakh of value. Check that directly: the tax paid is ₹12.50 lakh a year, worth 12.50 × 3.169865 = ₹39.62 lakh. The two agree, which confirms that the only tax effects in this appraisal are the ones identified.

5. 5Now pay the tax a year later

   Suppose each year's tax is settled one year after the profit arises. Nothing about the amounts changes; the whole ₹39.62 lakh tax stream simply moves one year further out, so it is discounted once more at 10%:

   39.62 ÷ 1.10 = ₹36.02 lakh
   NPV = 475.48 − 400 − 36.02 = +₹39.46 lakh

   Check it against the earlier figure: the deferral saved 39.62 − 36.02 = ₹3.60 lakh, and 35.86 + 3.60 = ₹39.46 lakh. The two routes agree. The company pays exactly the same rupees of tax and the project is worth ₹3.60 lakh more, purely because of when.

6. 6The interest trap, priced so it is not abstract

   Suppose ₹200 lakh of the machine is funded with a loan at 9%. The interest is ₹18 lakh a year, and the relief on it is 25% × 18 = ₹4.50 lakh a year, worth 4.50 × 3.169865 = ₹14.26 lakh.

   That ₹14.26 lakh is real, and it must not be added to the ₹35.86 lakh. Discounting at the company's 10% WACC has already allowed for the tax relief on its borrowing, because the WACC's cost of debt is an after-tax figure. Adding it again would overstate this project by ₹14.26 lakh, and would do so on every project the company ever appraises.

   The discipline is the one stated above: operating cash flows and the tax on them belong in the table, and everything about the financing belongs in the discount rate.

Where this fits in CB1

This page explains one idea from CB1 Business Finance. The full CB1 syllabus, with what each part is examined on, sits on the course page, and past-paper style mock exams with full solutions are where you find out whether the idea has stuck under time pressure.

Other CB1 topics explained

• Why financial reporting is regulated, and who it is regulated for
• Share capital and loan capital: why each source costs what it does
• Leasing against buying, and the only comparison that settles it
• Profit is not cash, and why a growing company can run out of money
• Return on capital employed, and the two things that drive it
• Gearing: why borrowing magnifies a shareholder return in both directions
• Modigliani-Miller: why gearing does not create value, and what does
• Dividend irrelevance, and the four reasons dividends still matter
• The cost of capital, and why a project must beat the whole pot
• NPV against IRR, and the three times IRR gives the wrong answer
• Working capital: the days between paying out and being paid
• Valuing a company: discounted cash flow against comparable multiples
• Synergies and the takeover premium: who actually gets the gain
• Interest rate swaps: fixing a floating cost, and where the saving comes from
• Hedging currency risk: the forward contract and the money-market hedge

Stuck on a term rather than the idea? The actuarial glossary defines the notation used above. If something here is wrong or unclear, tell us — these pages get corrected.