Companies are generally liable to pay corporation tax on their profits after certain adjustments, and more taxable profits mean more corporation tax. This impacts the cash flows of the company—an increase in the tax payments increases the cash flows out of the company. A company usually has up to nine months after the financial year-end in which to pay its corporation tax, although, for practical convenience in cash flow appraisals, a one-year time lag is conventionally assumed.
The timing effect of tax payments on cash flows can affect investment decisions. A second key factor concerns the capital allowances which a company is entitled to claim when it invests in certain types of assets. Mostly, depreciation is not allowed as an expense to be charged against profits. Capital allowances can be set against taxable profits, thus reducing a company’s tax liabilities and consequently the actual amount of tax paid to the government. In dealing with taxation in an investment appraisal, only the incremental cash flow effects are considered, which usually consist of the tax charged on the additional profits and the allowances obtainable on the initial capital invested.
Taxation implications on investment decisions have two diametrical effects:
- The consideration of taxation leaders to a correction of the input variable ‘cash flow’. The investment’s cash flow has to be reduced by the level of tax to be paid, and therefore the NPV drops in comparison with the NPV before taxes.
- Similarly, the discount rate changes. If the investment is financed with equity, then the net profit for the best opportunity changes through the tax burden. If the investment on the best opportunity is 5% before taxes and if the company is taxed at the rate of 40%, then, due to taxation, the interest rate falls to 3%. Financing the investment with debt capital also leads to lower discount rates because interest on debt is often tax-deductible. With a general tax rate of 40%, the cost of capital drops from 5% to 3%. Thus, the discount rate falls independently of the way the investment is financed. If the discount rate goes down, the NPV will go up compared to the NPV without taxes.
The first effect if greater than the second one, and the NPV after taxes is lower than the NPV before taxes. But if the effect on interest rates surmounts the drop of the cash flows, then the NPV can rise, and an investment project which had a negative NPV before taxes and which was therefore rejected can turn out to be acceptable. This is called the paradox of taxation. Price movement changing the level of consumption will influence the investment appraisal in two ways – on one side, it makes the estimate of the project’s cash flow more difficult, and on the other side, market interest rates can be expected to rise in case of general inflation. Thus, the investment appraisal must recognize expected inflation in the future cash flows and, in addition, use a discount rate reflecting the investors’ expectations about future inflation.