Advanced Financial Management · Discounted cash flow techniques

Relevant Cash Flows and Tax in AFM Project Appraisal

Updated 11 October 2026 · Fact-checked

A relevant cash flow is a future, incremental cash flow caused by accepting the project. Build the NPV from these: operating cash flows, working capital, tax and capital allowance savings, and opportunity costs. Ignore sunk costs, depreciation and financing flows. Discount nominal flows at a nominal rate, or real flows at a real rate.

Understand Relevant Cash Flows and Tax in Project Appraisal

A DCF appraisal asks one question: how much better off is the company if it accepts the project than if it does not? So you include only cash flows that change because of the decision. A relevant cash flow is future, incremental and cash.

This rules out several things. Sunk costs, such as a feasibility study already paid for, are gone whatever you decide. Depreciation is not a cash flow. Allocated head-office overheads are included only if they actually increase. Interest and dividends are left out because the financing cost is already inside the discount rate. Counting them would double count. Things to bring in are opportunity costs, such as contribution lost on existing products or the sale value of an asset you would otherwise sell, and indirect effects such as lost sales of other products.

Working capital is an investment. If the project needs extra inventory and receivables, cash goes out before the sales cash comes in. You include only the change in working capital each year, and you assume it is released at the end of the project unless told otherwise. When prices rise, the working capital balance usually has to rise too, so each year's top-up is a cash outflow.

Inflation must be treated consistently. Nominal (money) cash flows include inflation and are discounted at the nominal (money) rate. Real cash flows are at today's prices and are discounted at the real rate. The two methods give the same answer when one general rate of inflation applies to everything. If different items have different (specific) inflation rates, use the nominal method and inflate each item at its own rate.

Tax affects the operating cash flows and the cost of the asset. Profits are taxed, so the after-tax operating cash flow is lower. Capital allowances (tax-allowable depreciation) are not cash, but they reduce the tax bill, so the tax saving is the relevant cash flow. Watch the timing. Tax is paid either in the same year or one year later, as the question states. When the asset is sold, a balancing allowance or balancing charge settles the difference between the tax written-down value and the sale proceeds.

Key rules to remember

Relevant cash flow test: Include if: future AND incremental AND cash; Exclude sunk costs, depreciation, apportioned fixed overheads and financing flows (interest, dividends).
Nominal cash flow: Nominal CF in year n = Real CF × (1 + h)ⁿ; h is the inflation rate for that item. Use specific rates where the question gives them.
Fisher equation: (1 + money rate) = (1 + real rate) × (1 + inflation rate); Use it to move between real and nominal rates. Do not simply add the rates.
Working capital cash flow: Cash flow in year t = −(WC needed at end of t − WC needed at end of t−1); A rise is an outflow. A fall, including the final release, is an inflow. Inflate the balance if prices rise.
Tax on operating cash flow: Tax = pre-tax operating cash flow × tax rate; Apply it in the same year or one year later, as the question states.
Capital allowance tax saving: Tax saving = capital allowance × tax rate; Reducing-balance allowance = rate × tax written-down value (TWDV) at the start of the year.
Balancing allowance or charge: TWDV − disposal proceeds (positive = allowance, negative = charge); Normally claimed in the final year in place of the normal allowance.
NPV: NPV = Σ [CFₜ ÷ (1 + k)ᵗ] − initial investment; Use k as the money rate for nominal flows. Accept if NPV > 0.

How to solve Relevant Cash Flows and Tax in Project Appraisal questions

Use the same layout every time. A clear timeline table earns method marks even if one number is wrong.

1Read the requirement and note the key data: tax rate, tax timing, inflation rates, the discount rate and whether it is real or money, and the project life.
2List the relevant items and cross out the irrelevant ones: sunk costs, depreciation, allocated overheads and interest. Add opportunity costs.
3Decide the method. Use nominal flows and a money rate when inflation rates differ or tax is involved. Convert the discount rate with the Fisher equation if needed.
4Build the timeline from time 0. Inflate revenues and costs, then compute the tax on the operating profit. Calculate capital allowances and their tax savings, including the balancing figure in the final year.
5Add working capital changes and the asset sale proceeds, with any related tax effect. Make sure tax is in the right year.
6Total the net cash flow for each year, apply the discount factors and calculate the NPV.
7State the decision (accept if NPV is positive), then add key assumptions and risks, for example the sensitivity of inflation or the working capital release.

Quickest way: Single-table nominal NPV layout

When to use it: Use it for any question with inflation and tax where you are short of time. One table keeps timing errors out.

Set up columns for years 0 to n and rows for revenue, costs, pre-tax cash flow, tax, allowance saving, working capital, asset flows, net cash flow, discount factor and present value.
Fill the pre-tax cash flow row first, inflated to money terms.
Compute tax as 25% (or the given rate) of that row, shifted by one year if tax is paid in arrears.
Work out the allowance schedule in a small side box and enter only the tax savings.
Enter working capital changes as a separate row and then sum down each column.

Common mistakes in Relevant Cash Flows and Tax in Project Appraisal

Discounting nominal cash flows at a real rate (or real flows at a money rate).
The question gives one rate and students use it without checking what it represents.
Fix: Label every rate and cash flow as real or nominal before you start. Convert with the Fisher equation if they do not match.
Including depreciation, interest or sunk costs.
These items appear in the data and look like costs.
Fix: Apply the test future, incremental and cash. Say in one line why you excluded each item, as the marker rewards this.
Deducting the whole working capital balance every year instead of the change.
Students treat working capital as a running cost rather than an investment.
Fix: Calculate the closing balance for each year, then take the difference from the previous year. Release the final balance at the end.
Using the capital allowance itself as a cash flow instead of the tax saving.
Allowances appear in the data as large numbers, and students forget that they only reduce tax.
Fix: Multiply each allowance by the tax rate and put only the saving in the timeline, in the correct year.
Putting tax in the wrong year or ignoring the final-year balancing figure.
The timing statement is easy to miss, and the sale proceeds make the final year look complete.
Fix: Underline the tax timing in the question. In the last year, compute TWDV minus proceeds and claim it as a balancing allowance or charge.
Applying general inflation to everything when specific rates are given.
Students take a shortcut to save time.
Fix: Inflate each item at its own rate. If specific rates differ, the nominal method is the only reliable approach.

Worked examples

Example 1

A company is considering a machine costing $1,600,000 at time 0. It will earn pre-tax operating cash flows of $800,000 a year at current prices for four years, inflating at 5% a year. Tax is 25%, paid in the same year as the profit. Capital allowances are 25% reducing balance, with a balancing adjustment in year 4. The machine will be sold at the end of year 4 for $475,000. The money discount rate is 12%. Ignore working capital. Calculate the NPV. Discount factors at 12%: year 1 0.893, year 2 0.797, year 3 0.712, year 4 0.636.

Show the solution

Inflate the operating cash flows: year 1 $840,000; year 2 $882,000; year 3 $926,100; year 4 $972,405.
Tax at 25%: $210,000; $220,500; $231,525; $243,101. After tax: $630,000; $661,500; $694,575; $729,304 (rounded).
Capital allowances: year 1 25% × 1,600,000 = 400,000 (TWDV 1,200,000); year 2 300,000 (TWDV 900,000); year 3 225,000 (TWDV 675,000). In year 4 the balancing allowance = 675,000 − 475,000 = 200,000.
Tax savings at 25%: year 1 $100,000; year 2 $75,000; year 3 $56,250; year 4 $50,000.
Net cash flows: year 1 = 630,000 + 100,000 = 730,000. Year 2 = 661,500 + 75,000 = 736,500. Year 3 = 694,575 + 56,250 = 750,825. Year 4 = 729,304 + 50,000 + 475,000 = 1,254,304.
Present values: 730,000 × 0.893 = 651,890. 736,500 × 0.797 = 586,991. 750,825 × 0.712 = 534,587. 1,254,304 × 0.636 = 797,737.
Total PV = $2,571,205. NPV = 2,571,205 − 1,600,000 = $971,205.

Answer: NPV is approximately +$971,000. The project is financially acceptable, subject to the assumptions on inflation and sales proceeds.

Example 2

A two-year project needs an initial outlay of $1,500,000. After-tax operating cash flows are $1,000,000 a year at current prices, subject to general inflation of 5% a year. It also needs working capital of $200,000 at time 0 (current prices), which must rise with inflation and is fully recovered at the end of year 2. The real cost of capital is 5%. Calculate the NPV using the nominal method.

Show the solution

Convert the rate: (1 + money rate) = 1.05 × 1.05 = 1.1025, so the money rate is 10.25%.
Inflate the operating cash flows: year 1 = 1,000,000 × 1.05 = 1,050,000. Year 2 = 1,000,000 × 1.05² = 1,102,500.
Working capital balances rise with inflation: time 0 = 200,000; year 1 = 200,000 × 1.05 = 210,000; year 2 = 200,000 × 1.05² = 220,500.
Take the changes in the balance: time 0 outflow 200,000; year 1 outflow 10,000 (210,000 − 200,000); year 2 top-up outflow 10,500 (220,500 − 210,000). The full balance of 220,500 is then released at the end of year 2. Netting the year 2 top-up and the release gives −10,500 + 220,500 = +210,000 at time 2.
Net cash flows: time 0 = −1,500,000 − 200,000 = −1,700,000. Year 1 = 1,050,000 − 10,000 = 1,040,000. Year 2 = 1,102,500 + 210,000 = 1,312,500.
Discount factors: 1 ÷ 1.1025 = 0.9070 and 1 ÷ 1.1025² = 0.8227.
PV year 1 = 1,040,000 × 0.9070 = 943,280. PV year 2 = 1,312,500 × 0.8227 = 1,079,794. Total = 2,023,074.
NPV = 2,023,074 − 1,700,000 = $323,074.

Answer: NPV is approximately +$323,000, so accept. The working capital note matters: the balance was inflated, topped up in years 1 and 2, and the full balance of $220,500 was released at the end of year 2.

Exam tips

Write the tax timing, the inflation basis and the type of discount rate at the top of your answer. Markers give credit for correct assumptions even when the arithmetic slips.
In a scenario question, add a short comment on the key judgements, such as the opportunity cost of the asset or the risk in the working capital release. This earns professional skills marks for analysis and commercial acumen.
Show the allowance schedule separately, with the balancing figure labelled. Method marks are often awarded for the TWDV and the tax saving timing.
State which cash flows you have excluded and why, in one line each. It shows you understand relevance and protects marks if the marker disagrees with a figure.
Finish with a clear recommendation based on NPV, then name one or two limits, such as forecast inflation or sales risk.

Practice questions from Discounted cash flow techniques

Relevant Cash Flows and Tax in Project Appraisal in other exams

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

Relevant Cash Flows and Tax in Project Appraisal: frequently asked questions

How do I treat inflation in NPV in AFM?

Use the nominal method unless the question is simple. Inflate each cash flow at its own rate and discount at the money rate. If you are given a real rate, convert it with (1 + money) = (1 + real) × (1 + inflation).

Do I include working capital in the NPV?

Yes, as the change in working capital each year. An increase is an outflow and a decrease is an inflow. Release the remaining balance at the end of the project unless the question says otherwise.

How do capital allowances enter an NPV?

Capital allowances are not cash flows. The relevant cash flow is the tax saving, which equals the allowance times the tax rate. Put it in the year the tax is actually paid or saved, and include the balancing allowance or charge in the final year.

Should interest be included in the project cash flows?

No. The financing cost is already part of the discount rate, so including interest would double count it. The exception is when you use a method such as APV, where financing side effects are valued separately.

Can I use real cash flows when tax is involved?

It is risky. Capital allowances are based on historic cost, so they do not rise with inflation, and tax timing adds more complexity. The nominal method handles these correctly, so use it for any question with tax.