The treatment of taxation in capital investment appraisal

Abstract

Investment appraisal techniques such as the net present value and the internal rate of return methods are frequently used to assess the worthwhileness of a capital investment. A number of factors will influence the outcome of an investment appraisal exercise including inflation, finance and taxation. While there can be no excuse for ignoring the effects of inflation in an investment appraisal the other two factors are frequently ignored. The rationale for this is that financing requirements and tax liability differ from business to business even though the projects under consideration are identical. Variations in the financing and tax situation will lead to variations in the results of the appraisal which have nothing to do with the intrinsic merit of the project. Excluding finance and tax enables an appraisal to be made of a project in general terms. This is termed general financial analysis. Once a general financial analysis has been carried out and the project has been shown to be worthwhile in general terms, then the appraisal can be reworked incorporating the individual developer's specific finance requirement and tax situation. This is known as specific financial management. Although cumbersome it is argued that this two stage approach is logical because the general financial analysis, which is relatively straightforward, can be used as a screening procedure before carrying out the more complex financial analysis only on these projects which have passed the initial screening. Great care must be exercised in deciding which projects to reject at this stage since the effects of differing marginal tax rates and depreciation allowances can render some apparently marginal projects worthwhile (e.g. Burrell et al). The second stage of the assessment is often incorrectly omitted because of the complexities associated with the inclusion of tax payments and reliefs in the appraisal procedure. It is the purpose of this report to consider the different ways of dealing with taxation in investment appraisal and to present a set of tables that can be used to ease the calculation procedures. The interrelationship between tax, inflation and finance in investment appraisal will also be considered.