BUSF_A01.qxd

Taxation

Forecasting cash flows

Investment appraisal deals with forecasts of future cash flows. Forecasting the cash

flows associated with particular courses of action is likely to be difficult, and subject

to error. Details of the techniques and problems of forecasting go beyond the scope of

this book. These techniques include the use of statistical data on past events (gener-

ated inside and outside the business), market research projects and soliciting the opin-

ions of experts.

11.10 Gearing and the cost of capital – conclusion

One type of cash flow that should not be included in the appraisal is the cost of finance

to support the project. Discounting deals with the financing cost in a complete and log-

ical manner in that future cash flows are reduced (discounted) to take account of the

time for which finance will be tied up and the relevant interest rate.

So far we have referred to the cost of financing as ‘interest’, as though all finance

is provided through borrowing. In practice, most businesses are financed by a mix-

ture of funds provided by the owners (shareholders in the case of limited companies)

and borrowing. Thus the financing cost is partly the cost of equity and partly interest

cost. We tend to use the expression cost of capitalfor the overall cost of financing

and for the basis of the discount rate. This expression will generally be used from

now on.

We shall review in some detail how an appropriate cost of capital figure is derived

later in the book, particularly in Chapter 10.

5.5 Taxation

Cash flows associated with taxation must be brought into the assessment of the pro-

ject. Most projects will cause differences in corporation tax. This may be because of

capital expenditure attracting relief (capital allowances), profits from the project

attracting additional tax or losses attracting tax relief. These differences must be taken

into account in investment appraisal.

The taxable profit

Businesses are taxed on the basis of the profit shown by an income statement drawn

up following the generally accepted accounting rules and conventions. This profit

figure is, however, subject to some adjustment. There are certain items of expense and

revenue that, though legitimately appearing in the income statement, have been sin-

gled out by the law as being illegitimate for tax purposes.

Most of these items are fairly unusual in occurrence or relatively insignificant in

effect, though there is one that is typically neither rare nor trivial. This is depreciation,

the accounting device for spreading capital costs of non-current assets over their use-

ful lives. For tax purposes, depreciation must be added back to the profit revealed by

the income statement, to be replaced by capital allowances.

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