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Financial Management · Allowing for inflation and taxation in DCF

Taxation and Capital Allowances in DCF Appraisal

Updated 11 October 2026 · Fact-checked

In DCF, tax is a cash flow. Tax operating cash flows at the given rate. Add the tax saved on tax-allowable depreciation (allowance × tax rate), and use a balancing allowance or charge when the asset is sold. Ignore accounting depreciation. Put each tax flow in the year it is paid, which may be one year late.

Understand Taxation in DCF and Capital Allowances

A project pays tax on the extra profit it earns. So an NPV that ignores tax overstates the cash the business keeps. In FM you add tax as a separate set of cash flows and then discount everything, using the after-tax cost of capital if one is given.

Tax is charged on taxable profit, not on cash flow. Taxable profit is the operating cash flow minus the tax-allowable depreciation (TAD), also called a capital allowance or writing down allowance. The tax authority lets you deduct the cost of the asset gradually. You do not deduct accounting depreciation. It is a non-cash accounting entry and the tax rules ignore it.

The allowance itself is not a cash flow. The cash flow is the tax saved: TAD × tax rate. The question will state the method. Under reducing balance, you claim a percentage of the opening written down value (WDV) each year. Under straight line, you claim the same amount each year, usually (cost − residual value) ÷ number of years.

When the asset is sold, or at the end of the project, compare the sale proceeds with the WDV. If proceeds are lower than WDV, you get a balancing allowance of WDV − proceeds. That is extra tax relief. If proceeds are higher, you get a balancing charge, which increases taxable profit. Over the whole life, total allowances equal cost minus final proceeds.

Timing matters. Some questions say tax is paid in the same year as the profit. Others say it is paid one year in arrears. In that case, tax on year 1 profits is a cash flow in year 2, and so on. This creates a final tax flow one year after the last profit. Follow the question wording exactly.

Key rules to remember

Tax on operating cash flow
Tax = Operating cash flow × tax rate
This is the simple version. It applies when you work with cash flows and allowances separately. Tax on profits is a cash outflow. A tax-allowable loss may give relief if the question says so.
Tax saved on allowance
Tax saving = TAD × tax rate
The allowance is not a cash flow. Only the tax saving goes into the NPV.
Reducing balance TAD
TAD = allowance rate × opening WDV; closing WDV = opening WDV − TAD
The rate is given in the question. Check when the first allowance is claimed. Often it is year 1 for an asset bought at time 0.
Straight line TAD
TAD per year = (cost − residual value) ÷ number of years
Use the tax life given in the question, not the accounting life, if they differ.
Balancing allowance or charge
WDV at disposal − sale proceeds. Positive = balancing allowance. Negative = balancing charge.
Claim it in the year of disposal. Then work out the tax effect: amount × tax rate.
Tax timing
Tax paid in year n + 1 = tax on profits of year n (if one year in arrears)
The last year's tax is paid in the year after the project ends. Show it as a separate cash flow.

How to solve Taxation in DCF and Capital Allowances questions

Use this layout for any DCF question with tax. Work in a table with one column for each year, starting at time 0.

  1. 1Read the tax rules in the question: the tax rate, the TAD method and rate, when the first allowance is claimed, and whether tax is paid in the same year or one year in arrears.
  2. 2List the pre-tax cash flows: capital cost, operating cash flows, working capital, and sale proceeds. Leave out accounting depreciation and any financing cost.
  3. 3Calculate tax on the operating cash flows: operating cash flow × tax rate for each year.
  4. 4Build the TAD schedule: opening WDV, TAD, closing WDV. In the last year, compare proceeds with WDV and find the balancing allowance or charge.
  5. 5Calculate the tax saving on each TAD and balancing amount: amount × tax rate.
  6. 6Combine the tax on operating cash flows and the tax savings in each year. Then move the net tax to the year it is actually paid or received.
  7. 7Add up the net cash flow in each year, discount at the cost of capital given, and sum to get the NPV. State the decision: accept if NPV is positive.

Quickest way: Net tax line method

When to use it: Use it when the question has several years and a reducing balance allowance. It keeps the table short and cuts down on timing errors.

  1. Make four rows: pre-tax cash flow, TAD, tax effect, net cash flow.
  2. Write the tax effect as (operating cash flow − TAD) × tax rate in one line. This gives the net tax for that year's profit.
  3. If tax is paid one year late, shift the whole tax row one column to the right. Do not shift the pre-tax row.
  4. Check that the sum of all TAD (including the balancing allowance) equals cost minus final proceeds. If it does not, you have made an error.
  5. Multiply by discount factors and total. Keep the working neat so you can earn method marks.

Common mistakes in Taxation in DCF and Capital Allowances

  • Deducting accounting depreciation when working out tax

    Students see a depreciation figure in the question and think it is a tax deduction.

    Fix: Ignore accounting depreciation. It is non-cash. Use only the TAD method that the question states.

  • Putting the allowance itself in the cash flows instead of the tax saved

    The allowance looks like a cash number in the schedule.

    Fix: Multiply every TAD and balancing allowance by the tax rate. Only that saving belongs in the NPV.

  • Forgetting the balancing allowance or charge on disposal

    Students claim the normal allowance in the final year and stop.

    Fix: In the year of sale, compare proceeds with the WDV. Claim the difference as a balancing allowance or charge instead of the normal allowance. Check that total allowances equal cost minus proceeds.

  • Getting tax timing wrong when it is paid one year in arrears

    Students put tax in the same column as the profit out of habit.

    Fix: Shift all the tax flows, including the tax saved on allowances, one year later. Add an extra column for the year after the project ends.

  • Treating the sale proceeds as taxable income as well as using the balancing allowance

    Students tax the proceeds and also claim a balancing adjustment, which counts the same item twice.

    Fix: The proceeds are a pre-tax cash inflow with no tax of their own. The tax effect comes only from the balancing allowance or charge.

  • Using a pre-tax cost of capital with after-tax cash flows

    Students pick the first rate they see.

    Fix: Use the discount rate the question gives for the project. If the question gives a WACC, use it. Do not adjust it unless asked.

Worked examples

Example 1

A machine costs $200,000 at time 0. Tax-allowable depreciation is 25% reducing balance, with the first claim in year 1. The tax rate is 30%, paid in the same year as the profit. The project lasts 4 years and the machine is sold for $60,000 at the end of year 4. The cost of capital is 10%. Calculate the tax saved each year and the present value of the tax savings. Discount factors at 10%: year 1 0.909, year 2 0.826, year 3 0.751, year 4 0.683.

Show the solution
  1. Year 1: TAD = 25% × $200,000 = $50,000. WDV = $150,000. Tax saved = 30% × $50,000 = $15,000.
  2. Year 2: TAD = 25% × $150,000 = $37,500. WDV = $112,500. Tax saved = 30% × $37,500 = $11,250.
  3. Year 3: TAD = 25% × $112,500 = $28,125. WDV = $84,375. Tax saved = 30% × $28,125 = $8,437.50.
  4. Year 4: The machine is sold for $60,000, so there is no normal allowance. Balancing allowance = $84,375 − $60,000 = $24,375. Tax saved = 30% × $24,375 = $7,312.50.
  5. Check: total allowances = $50,000 + $37,500 + $28,125 + $24,375 = $140,000. This equals cost less proceeds ($200,000 − $60,000). Total tax saved = $42,000.
  6. Present values: $15,000 × 0.909 = $13,635. $11,250 × 0.826 = $9,292.50. $8,437.50 × 0.751 = $6,336.56. $7,312.50 × 0.683 = $4,994.44.
  7. Sum = $13,635 + $9,292.50 + $6,336.56 + $4,994.44 = $34,258.50.

Answer: Tax saved is $15,000, $11,250, $8,437.50 and $7,312.50 in years 1 to 4. The present value of the tax savings is about $34,259. The $60,000 sale proceeds are a separate pre-tax inflow.

Example 2

A project needs equipment costing $90,000 at time 0. It has no residual value. Tax-allowable depreciation is straight line over 3 years, with the first claim in year 1. The project earns operating cash flows of $50,000 a year for 3 years. Tax is 20%, paid one year in arrears. The cost of capital is 10%. Discount factors: year 1 0.909, year 2 0.826, year 3 0.751, year 4 0.683. Calculate the NPV.

Show the solution
  1. TAD per year = $90,000 ÷ 3 = $30,000.
  2. Taxable profit each year = $50,000 − $30,000 = $20,000. Tax = 20% × $20,000 = $4,000 a year on the profits of years 1, 2 and 3.
  3. With one year's delay, the tax is paid in years 2, 3 and 4.
  4. Net cash flows: time 0 = −$90,000. Year 1 = $50,000. Year 2 = $50,000 − $4,000 = $46,000. Year 3 = $50,000 − $4,000 = $46,000. Year 4 = −$4,000.
  5. Present values: year 1 = $50,000 × 0.909 = $45,450. Year 2 = $46,000 × 0.826 = $37,996. Year 3 = $46,000 × 0.751 = $34,546. Year 4 = −$4,000 × 0.683 = −$2,732.
  6. Sum of inflows and outflows after time 0 = $45,450 + $37,996 + $34,546 − $2,732 = $115,260.
  7. NPV = $115,260 − $90,000 = $25,260.

Answer: The NPV is $25,260. It is positive, so the project should be accepted on financial grounds.

Exam tips

  • Underline the tax rules in the question first: the rate, the allowance method, the first claim year and the payment timing. Most lost marks come from missing one of these.
  • In objective test questions, one wrong step makes the whole answer wrong. Do the TAD schedule on the scratchpad and check that total allowances equal cost minus proceeds.
  • In constructed response questions, lay out a clear table with years across the top and labelled rows. Marks are given for each correct line, even if a later figure is wrong.
  • Only ever discount the tax saving, never the allowance. State your assumptions, for example the timing of the first allowance, if the question is unclear.
  • Add a short comment after the NPV. Say whether to accept, and mention one non-financial factor or assumption. Explain, for instance, that tax delays reduce the present value of tax paid.

Practice questions from Allowing for inflation and taxation in DCF

Taxation in DCF and Capital Allowances in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Taxation in DCF and Capital Allowances: frequently asked questions

What is the difference between tax depreciation and accounting depreciation in DCF?

Accounting depreciation is a non-cash accounting charge and is ignored in DCF. Tax-allowable depreciation is the deduction the tax rules give for the asset's cost. You use TAD to calculate the tax saved, and that saving is a cash flow.

How do I calculate tax saved on a writing down allowance?

Work out the allowance for the year, then multiply by the tax rate. For example, a $50,000 allowance at 30% tax saves $15,000. Put that saving in the correct year, which may be one year later if tax is paid in arrears.

What is a balancing allowance in an NPV question?

It is the extra relief when an asset is sold for less than its tax written down value. It equals WDV minus sale proceeds. Multiply it by the tax rate to get the cash saving. If the proceeds are higher than the WDV, you have a balancing charge and tax is payable.

How do I handle tax paid one year in arrears?

Calculate the tax on each year's profit, including the tax saved on allowances, as normal. Then move each amount to the next year. The tax on the last year's profit falls in a year after the project ends, so you need an extra column.