A project earns ₦40m of cash profit a year. The company does not keep ₦40m. The tax authority takes its share, and it also allows a deduction for the asset the company bought. Ignore tax and the project looks better than it is. Count the tax but forget the deduction and it looks worse. Tax cash flows can change the answer, so they belong in the appraisal.
This topic covers how tax enters discounted cash flow (DCF), the post-tax cost of capital, the timing of tax payments, tax-allowable depreciation (capital allowances) by the straight-line and reducing-balance methods, the timing of the tax saving, and balancing allowances and charges on disposal. The previous topic covered the internal rate of return, the modified internal rate of return and relevant costs.
The next covers inflation. The November 2014 Pathfinder paper included tax in its compulsory project question.
In 30 seconds
Tax is a cash flow. Higher profit means more tax; lower profit means less tax. Tax is usually charged on cash profit, in the same year or one year in arrears, as the question says. Interest is not a cash flow in DCF: its tax relief sits in the post-tax cost of capital, so post-tax cost of debt = pre-tax rate × (1 − tax rate).
Depreciation in the accounts is not tax-deductible. The tax rules give capital allowances instead, by straight-line or reducing balance. The cash flow is the tax saved (allowance × tax rate), not the allowance. On disposal, the balancing allowance (tax value above sale price) saves tax, and a balancing charge (sale price above tax value) costs tax. Over the asset’s life, total allowances equal cost minus sale proceeds.
Key terms in plain English
| Term | What it means |
|---|---|
| Post-tax cost of capital | The required return after allowing for tax relief on interest |
| Capital allowance | The tax rules’ version of depreciation, which reduces taxable profit |
| Tax written down value (TWDV) | Cost less the allowances claimed so far |
| Straight-line allowance | The same allowance every year |
| Reducing-balance allowance | A fixed percentage of the TWDV each year |
| Balancing allowance | An extra deduction when an asset is sold for less than its TWDV |
| Balancing charge | Extra taxable profit when an asset is sold for more than its TWDV |
| Tax in arrears | Tax paid one year after the profit it relates to |
Syllabus check
This topic is in syllabus area B (advanced investment appraisal, 30% of the marks). It covers:
- identifying tax cash flows in project appraisal;
- tax-allowable depreciation and balancing allowances and charges;
- DCF analysis with tax.
CAMA 2020 and tax in appraisal
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 305 | A director must act in good faith in the best interests of the company | Tax effects are part of the value a project adds |
| s. 308 | A director must use the care, diligence and skill of a reasonably prudent director | Directors should test the tax assumptions in an appraisal |
| s. 377(1) and s. 378 | Directors prepare statements that follow IFRS and give a true and fair view | Decisions later affect reported assets, profit and cash |
| s. 385 | The directors’ report covers performance and risk | Major plans and risks are reported to shareholders |
Under the Nigeria Tax Act 2025, in force from 1 January 2026, companies pay income tax at 30% of profits, and chargeable gains form part of those profits. A small company (turnover up to ₦100 million and fixed assets up to ₦250 million) is exempt from income tax and capital gains tax. Other companies also pay a development levy of 4% of assessable profits. In examination questions, use the rates and allowances given in the question.
Tax as a cash flow
When a project raises profits, tax rises. When it lowers profits, tax falls. In DCF it is normally assumed that tax is payable on the cash profit of each year. At 30%, a cash profit of ₦10,000 brings a tax payment of ₦3,000. Extra spending of ₦5,000 a year costs ₦5,000 but saves tax of ₦1,500.
Interest and the post-tax cost of capital
Interest is left out of DCF cash flows because the cost of capital already covers it. Interest is allowable for tax, so the discount rate is the post-tax cost of capital. For irredeemable debt: post-tax cost of debt = pre-tax interest × (1 − tax rate). At 10% interest and 30% tax, that is 10% × 0.7 = 7%.
Timing of tax
Two assumptions are used: tax is paid in the same year as the profit, or one year in arrears. The question should say which. ICAN’s example: a project costs ₦60,000 and returns ₦40,000 in year 1 and ₦50,000 in year 2. Tax at 30% is paid one year in arrears, there are no allowances and the post-tax cost of capital is 8%. Tax is ₦12,000 in year 2 and ₦15,000 in year 3. NPV = −60,000 + 40,000 × 0.926 + (50,000 − 12,000) × 0.857 − 15,000 × 0.794 = −₦2,304.
Capital allowances
Accounting depreciation is not allowed for tax. The tax rules give tax-allowable depreciation (capital allowances) instead. The accounting charge is ignored in DCF. The cash effect is the tax saved by the allowance, which is the allowance multiplied by the tax rate.
Straight-line
An asset costing ₦80,000 with a four-year allowance life has ₦20,000 allowed each year. At 30%, the tax saving is ₦6,000 a year for four years.
Reducing balance
Each year’s allowance is a fixed percentage of the TWDV at the start of the year. For ₦80,000 at 25%: year 1, ₦20,000 (TWDV ₦60,000); year 2, ₦15,000 (TWDV ₦45,000); year 3, ₦11,250 (TWDV ₦33,750); year 4, ₦8,438 (TWDV ₦25,312). The tax savings at 30% are ₦6,000, ₦4,500, ₦3,375 and ₦2,531.
Timing of the saving
Assumption 1: the allowance is claimed at the end of the year of purchase and the benefit comes at once (time 1). Assumption 2: it is claimed then but the tax effect comes a year later (time 2). Companies want the benefit early, so the usual assumption is that the first tax benefit comes one year after the date of purchase. If tax is paid in arrears, every saving moves back a further year. State your assumption if the question does not.
Balancing allowance and balancing charge
When the asset is sold, compare its TWDV with the proceeds. If TWDV is higher than the proceeds, there is a balancing allowance, an extra deduction that saves tax. If TWDV is lower, there is a balancing charge, extra taxable profit that costs tax. No ordinary allowance is claimed in the year of disposal.
Over the whole life, total allowances equal cost minus sale proceeds, so the total tax saved is the tax rate × (cost − proceeds).
ICAN’s example. An asset costing ₦80,000 earns cash inflows of ₦50,000, ₦40,000, ₦20,000 and ₦10,000 in years 1 to 4. It is sold for ₦20,000 at the end of year 4. Allowances are 25% reducing balance with the first benefit at time 1. Tax is 30%, paid one year in arrears. The post-tax cost of capital is 9%.
- Allowances: ₦20,000, ₦15,000, ₦11,250, ₦8,438. TWDV at the end of year 4 = ₦25,312. Proceeds ₦20,000 are lower, so there is a balancing allowance of ₦5,312.
- The model answer gives an NPV of about +₦22,800, so the project is accepted.
- Check.
total allowances = 20,000 + 15,000 + 11,250 + 8,438 + 5,312 = ₦60,000 = cost − proceeds (80,000 − 20,000).
The rules in more depth
Why the tax saving, not the allowance, is the cash flow
Only the saving in tax changes the bank balance. The allowance reduces taxable profit, and the saving is that reduction times the rate.
Why interest tax relief is not counted twice
It is in the post-tax discount rate. Adding it again to the cash flows would overstate NPV.
Why timing matters
A saving in year 1 is worth more than the same saving in year 2. The assumption you choose changes the NPV, so state it.
Why a balancing adjustment follows disposal
The allowances claimed must add up to cost less proceeds, so the tax system corrects any over- or under-claim when the asset goes.
Effect on analysis
Build a table of TWDV, allowance and tax saved. Move each saving to the year the cash arrives. Then discount all the flows together.
Worked examples
Example 1: straight-line. An asset costs ₦200,000. Allowances are straight-line over 5 years with no residual value. Tax is 30%.
- Annual allowance.
200,000 ÷ 5 = ₦40,000. - Annual tax saving.
40,000 × 30% = ₦12,000. - Total saved over 5 years = ₦60,000 = 30% × 200,000.
Example 2: post-tax cost of debt. A company pays 14% on a loan. Tax is 30%.
- Post-tax cost.
14% × (1 − 0.30) = 9.8%. - This is the rate used to discount financing cash flows (as in the lease or buy decision later).
- The tax relief on interest is already inside this rate.
Example 3: balancing charge. An asset costs ₦100,000. Allowances are 25% reducing balance. After three years the TWDV is ₦42,188. It is sold for ₦60,000.
- Allowances: 25,000; 18,750; 14,063.
TWDV = 100,000 − 57,813 = ₦42,188. - Proceeds 60,000 exceed TWDV by ₦17,812, a balancing charge.
- Extra tax.
17,812 × 30% = ₦5,344.
Example 4: balancing allowance. The same asset is instead sold for ₦30,000.
- TWDV ₦42,188 is above the proceeds by ₦12,188, a balancing allowance.
- Tax saved.
12,188 × 30% = ₦3,656. - Total allowances.
25,000 + 18,750 + 14,063 + 12,188 = ₦70,000 = cost − proceeds.
How to score full marks
- State your assumptions on the timing of tax and of the first allowance.
- Tabulate the TWDV, the allowance and the tax saved.
- Include the balancing adjustment in the year of disposal.
- Tax the cash profit, not the accounting profit, and ignore depreciation.
- Discount at the post-tax rate.
- Check that total allowances equal cost minus proceeds.
Common mistakes in the exam
- Treating the allowance, not the tax saved, as the cash flow.
- Deducting accounting depreciation from cash profit before tax.
- Claiming an ordinary allowance in the year of disposal.
- Putting the tax saving in the wrong year.
- Adding interest to cash flows and also using a post-tax rate.
- Using the pre-tax rate to discount post-tax flows.
Quick revision
- Tax on cash profit; same year or one year later.
- Post-tax cost of debt = rate × (1 − tax).
- Allowances give tax savings; straight-line or reducing balance.
- Balancing allowance if sale is below TWDV; balancing charge if above.
- Total allowances = cost − proceeds.
- CAMA 2020: ss. 305, 308, 377(1), 378, 385.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. Interest on project finance is:
- Included in the cash flows
- Left out of the cash flows and covered by the post-tax discount rate
- Added to NPV
- Taxed twice
Show the answer
B. The cost of capital already covers it.
Question 2. The post-tax cost of 10% debt at 30% tax is:
- 3%
- 7%
- 10%
- 13%
Show the answer
B. 10% × 0.7.
Question 3. In DCF, accounting depreciation is:
- Deducted before tax
- Ignored, with capital allowances used instead
- Added to profit
- Discounted
Show the answer
B. It is not tax-allowable.
Question 4. The cash flow from a capital allowance is:
- The allowance itself
- The tax saved on it
- The accounting depreciation
- Nil
Show the answer
B. Allowance × tax rate.
Question 5. A reducing-balance allowance is a percentage of:
- Cost each year
- The TWDV at the start of the year
- Sales
- Profit
Show the answer
B. It falls each year.
Question 6. A balancing charge arises when:
- Sale proceeds exceed the TWDV
- Sale proceeds are below the TWDV
- The asset is not sold
- Tax is paid early
Show the answer
A. It is extra taxable profit.
Question 7. Over an asset’s life, total allowances equal:
- Cost
- Cost minus sale proceeds
- Proceeds
- Cost plus proceeds
Show the answer
B. Balancing adjustments make this true.
Question 8. If tax is paid one year in arrears, a tax saving on a year 1 allowance falls in year:
- 0
- 1
- 2
- 3
Show the answer
C. One year later.
Question 9. A balancing allowance arises when:
- Proceeds are below TWDV
- Proceeds are above TWDV
- Tax rates rise
- No asset is sold
Show the answer
A. It is an extra deduction.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) Explain why accounting depreciation is ignored in DCF but capital allowances are included. (4 marks) (b) Explain a balancing allowance and a balancing charge. (4 marks) (c) State why the discount rate is post-tax. (2 marks)
Question 12 (20 marks). Lagos Plc will buy equipment for ₦100m. It will earn cash profits of ₦40m a year for four years before tax and be sold for ₦30m at the end of year 4. Tax is 30%, paid in the same year. Allowances are 25% reducing balance, claimed from year 1, with a balancing adjustment in year 4. The post-tax cost of capital is 10% (factors 0.909, 0.826, 0.751, 0.683).
(a) Calculate the allowances and the tax saved in each year. (6 marks) (b) Calculate the NPV and advise. (8 marks) (c) Explain how the NPV changes if tax is paid one year in arrears. (3 marks) (d) Explain why interest is excluded. (3 marks)
Question 13 (10 marks). (a) A company borrows at 14% and pays tax at 25%. Calculate the post-tax cost of debt. (2 marks) (b) An asset costing ₦200,000 has a straight-line allowance over 5 years, with no residual value. Calculate the annual tax saving at 30% and the total over the life. (4 marks) (c) The asset is instead sold after 3 years for ₦90,000 when the TWDV is ₦80,000. State the balancing adjustment and its tax effect. (4 marks)
Model answers
Show the model answer to Question 11
(a) Depreciation and allowances (4 marks). Depreciation is not a cash flow and is not allowed for tax, so it is ignored. (2) Capital allowances reduce taxable profit and so save tax, which is a cash flow. (2)
(b) Balancing adjustments (4 marks). A balancing allowance arises when the TWDV is above the proceeds, giving an extra deduction and a tax saving. (2) A balancing charge arises when proceeds are above the TWDV, giving extra taxable profit and more tax. (2)
(c) Post-tax rate (2 marks). The tax relief on interest is already inside the post-tax cost of capital, so cash flows are discounted at that rate. (2)
Show the model answer to Question 12
(a) Allowances (6 marks).
- Year 1: 25% × 100,000 = ₦25.0m, saving ₦7.5m.
- Year 2: 25% × 75,000 = ₦18.75m, saving ₦5.625m.
- Year 3: 25% × 56,250 = ₦14.06m, saving ₦4.22m.
- TWDV after year 3 = ₦42.19m.
- Year 4: proceeds ₦30m, so balancing allowance = ₦12.19m, saving ₦3.66m.
- (1.5 each)
(b) NPV (8 marks).
- Tax on profit.
30% × 40 = ₦12m, so net profit ₦28m. (1) - Year 1: 28 + 7.5 = 35.5.
- Year 2: 28 + 5.625 = 33.625.
- Year 3: 28 + 4.22 = 32.22.
- Year 4: 28 + 3.66 + 30 = 61.66. (3)
- PVs.
35.5 × 0.909 = 32.27 - 33.625 × 0.826 = 27.77
- 32.22 × 0.751 = 24.20
- 61.66 × 0.683 = 42.11.
- Total = 126.35. (3)
- NPV = 126.35 − 100 = +₦26.4m.
- Accept. (1)
(c) Arrears (3 marks). Tax payments and tax savings both move back one year, so the tax cost on profits and the allowance benefits are discounted more heavily. (1.5) Because tax on profits exceeds the allowances in most years, NPV would normally rise. A final year of tax would also appear in year 5. (1.5)
(d) Interest (3 marks). The cost of capital already reflects the return lenders and shareholders require, and its tax relief is in the post-tax rate. (1.5) Including interest as a cash flow would count it twice. (1.5)
Show the model answer to Question 13
(a) Post-tax cost (2 marks). 14% × (1 − 0.25) = 10.5%. (2)
(b) Straight-line (4 marks).
- Allowance = 200,000 ÷ 5 = ₦40,000. (1)
- Annual saving.
40,000 × 30% = ₦12,000. (1.5) - Total = 5 × 12,000 = ₦60,000. (1.5)
(c) Disposal (4 marks).
- Proceeds ₦90,000 exceed the TWDV of ₦80,000 by ₦10,000, a balancing charge. (2)
- Extra tax.
10,000 × 30% = ₦3,000. (2)
Pathfinder on Tax, capital allowances and balancing adjustments in NPV
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
The compulsory cement project question included tax at 25% paid in the year the profit is made, with a tax allowance on plant and equipment claimed evenly over five years with nil scrap value. The model answer takes tax on operating profit and adds a yearly tax saving on the allowance of ₦75m (25% of ₦300m). It leaves out loan repayments and interest. Read the sections on capital allowances and the worked examples.
Revise first: Capital allowances
Questions ask for tax on profits, the saving from allowances and the balancing adjustment, with the timing stated. See the section on tax as a cash flow.
Revise first: Tax as a cash flow
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: November 2014 question 1(b).
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