Capital Investment Appraisal, Tax and Depreciation – The Basics

How can you decide whether to buy a fixed asset or to rent it? How do you evaluate and compare capital expenditure requests?

There are 4 key techniques used:

1. Pay Back Period – how many years does it take to get back your initial investment in profits – for normal investments anything less than 3 years is considered good

2. Average Rate of Return (ARR) – this method of appraisal takes the average of the profits made over say a 3 year period (or the life of an asset) and shows the result as a % of the initial investment

3. Net Present Value/Discounted Cash Flow – this method of appraisal takes into account the time value of returns, its often considered the best and most precise way to assess returns, to calculate the Net Present Value you create a cash flow table year 0, shows the investment as a cost, then the net profits are shown in the subsequent years and a factor is applied to remove the effect of inflation, the higher the NPV the better the investment

4. Internal Rate of Return – this is also described as the effective interest rate, to calculate this we increase the Discount Rate in the DCF (3 above) until the NPV equals zero and that produces the return rate

Many businesses will seek to match the funding of the asset to its useful economic life through either a loan or lease, as the life of the asset will normally exceed the pay back period, this should lead to increased profits compared to renting the asset.

Assets are depreciated in the business accounts

Depreciation means the cost of the asset is spread, so it is written off against the profits of several years rather than just the year of purchase. Depreciation is not allowable for tax. Instead you may be able to claim the cost of some assets against taxable income as capital allowances.

The most common methods of Depreciation are Straight Line (depreciation is the same amount in each year) and Reducing Balance (the amount of depreciation decreases each year and is a percentage of the net book balance).

From April 2012 the rates of capital allowances will be reduced from (a) 20% to 18% and from on the Main Rate Pool (b) 10% to 8% for  ‘special rate’ expenditure respectively. At the same time the maximum amount of the Annual Investment Allowances (AIA) will be reduced to £25,000 a year (currently £100,000). So you might want to consider buying assets prior to April 2012 to take advantage of the current rates.

Click to access bn04.pdf

There will be a timing difference between Depreciation and Capital Allowances and the Tax on the difference in rates is calculated and shown in the accounts as a Provision for Deferred Tax.