CAPITAL INVESTMENT ANALYSIS AND INFLATION AND CAPITAL INVESTMENT ANALYSIS WITH TAXATION
COVENANT UNIVERSITY, OTA
COLLEGE OF DEVELOPMENT STUDIES
DEPARTMENT OF FINANCE
ALPHA SEMESTER 2013/2014 ACADEMIC SESSION
LECTURE NOTE: BFN 411- FINANCIAL MANAGEMENT
WEEK 2 - 3
TOPIC - CAPITAL INVESTMENT ANALYSIS AND INFLATION AND CAPITAL INVESTMENT ANALYSIS WITH TAXATION
OBJECTIVE
At the end of this lecture, the students should be able to:
1. Explain the nature of inflation
2. Distinguish between money cash flow and real cash flow
3. Distinguish between money and real discount rates
4. Compute impact of inflation on discounted cash flow.
5. Explain investment incentives - capital allowance, annual allowance initial allowance
6. Compute impact of tax on capital investment
Introduction
Inflation refers to persistent increase in price of goods and services. It is also referred to as average general increases in the price of goods and services. Prior to this time, there had been lots of argument amongst writers in finance on whether or not to ignore or include inflation when computing capital budgeting. The argument has always being that inflation affects both the discount rate and the cash flow hence the effect will always cancel out. During inflation shareholders will always demand for higher rate of return because inflation has a way of eroding the purchasing power of the shareholders but the impact of inflation on the company 's rate of return and the expected cash flow are not always the same. Shareholders are not likely to reflect the entire inflation rate on a single investment because of risk diversification strategy employed by most shareholders.
Besides, inflation will not affect all the cash flows in exactly the same way. The impact of inflation on labour for instance will not be the same for material cost and cannot automatically reflect on selling price. Whichever way it is, the question is,
How do we incorporate the effect of inflation in capital investment decisions?
How do we adjust for inflation?
Will
COLLEGE OF DEVELOPMENT STUDIES
DEPARTMENT OF FINANCE
ALPHA SEMESTER 2013/2014 ACADEMIC SESSION
LECTURE NOTE: BFN 411- FINANCIAL MANAGEMENT
WEEK 2 - 3
TOPIC - CAPITAL INVESTMENT ANALYSIS AND INFLATION AND CAPITAL INVESTMENT ANALYSIS WITH TAXATION
OBJECTIVE
At the end of this lecture, the students should be able to:
1. Explain the nature of inflation
2. Distinguish between money cash flow and real cash flow
3. Distinguish between money and real discount rates
4. Compute impact of inflation on discounted cash flow.
5. Explain investment incentives - capital allowance, annual allowance initial allowance
6. Compute impact of tax on capital investment
Introduction
Inflation refers to persistent increase in price of goods and services. It is also referred to as average general increases in the price of goods and services. Prior to this time, there had been lots of argument amongst writers in finance on whether or not to ignore or include inflation when computing capital budgeting. The argument has always being that inflation affects both the discount rate and the cash flow hence the effect will always cancel out. During inflation shareholders will always demand for higher rate of return because inflation has a way of eroding the purchasing power of the shareholders but the impact of inflation on the company 's rate of return and the expected cash flow are not always the same. Shareholders are not likely to reflect the entire inflation rate on a single investment because of risk diversification strategy employed by most shareholders.
Besides, inflation will not affect all the cash flows in exactly the same way. The impact of inflation on labour for instance will not be the same for material cost and cannot automatically reflect on selling price. Whichever way it is, the question is,
How do we incorporate the effect of inflation in capital investment decisions?
How do we adjust for inflation?
Will
Links: Ltd is considering investing in a project that will involve purchase of plant and machinery costing N150,000.The plant and machinery are expected to have a life span of 5 years and a residual value of N8,000. the project will generate cash profits as follows: Year Cash profits (N) 1 58,000 2 60,000 3 62,000 4 55,000 5 54,000 Capital allowance is available on the plant and machinery at the rate of 25% of cost on the reducing balance basis. Tax is currently payable at 35% payable one year in arrears. The company 's after tax cost of capital is 18%.advise if the project is worthwhile.