A project is taxed like any other source of profit, and the tax changes the answer. The company pays tax on the extra profit the project earns, which reduces the cash it keeps; but it also gets tax relief on the cost of the machine in the form of capital allowances, which are the tax system’s version of depreciation.
Accounting depreciation is ignored in appraisal because it is not a cash flow, yet the tax relief it produces under the rules of the tax law is a real cash saving.
This topic explains how tax enters the cash flows, why interest is handled through the discount rate, the effect of the timing of tax payments, how capital allowances work under the Nigeria Tax Act 2025 (straight line, in three classes, with no initial allowance) and under a reducing balance method for questions that specify it, the balancing charge on disposal, and a full after-tax net present value (NPV) example. The next topic covers inflation in discounted cash flow.
The syllabus asks candidates to calculate the tax effects of relevant cash flows, including the tax benefits of tax-allowable depreciation. Read the internal rate of return and net present value first.
In 30 seconds
Tax is added to the cash flows: tax on the extra operating profit reduces the inflow, and capital allowances reduce taxable profit and so create a tax saving (allowance × tax rate). Interest is not deducted from the cash flows; its tax relief is allowed for in the (after-tax) cost of capital. Cash flows are timed when tax is actually paid, often one year in arrears.
Under the Nigeria Tax Act 2025 (from 1 January 2026) capital allowances are straight line on cost at 10%, 20% or 25% by class of asset, the initial allowance is abolished. A small value is retained until disposal. When an asset is sold, the difference between the sale proceeds and the retained tax value is a balancing charge (taxable) or balancing allowance (relief).
Tax in the cash flows
The tax cash flows in an appraisal are:
- Tax on the operating cash flow: tax rate × taxable profit from the project. Taxable profit is the cash profit less capital allowances (not accounting depreciation).
- Tax relief on capital allowances: each year’s allowance × tax rate reduces the tax payable.
- Tax on disposal: a balancing charge on selling the asset for more than its tax value, or relief on a balancing allowance if it sells for less.
A company with profits from other activities gets the benefit of the allowance in full; a company without other profits would carry the relief forward.
The tax rate for companies other than small companies under the Nigeria Tax Act 2025 is 30% (small companies are exempt, and the Act allows the rate to be reduced to 25% on the advice of the National Economic Council), with a separate 4% development levy on the assessable profits of large companies, which is outside this course’s exam conventions unless a question includes it.
Interest and tax
Interest is deductible for tax, but it is not included in the project’s cash flows. The financing cost is in the discount rate, and the tax saving from interest is allowed for by using the after-tax cost of debt in the cost of capital. For example debt costing 14% before tax, with tax at 30%, costs 14% × (1 − 0.30) = 9.8% after tax.
Timing
Tax is not paid on the day the profit is earned. A question will say when: in the same year as the profit or one year later (in arrears). The cash flow is placed in the year the tax is paid. A year’s delay lowers the present value of the tax paid, which helps the NPV.
Capital allowances
Capital allowances are the tax deduction for the cost of capital assets, in place of accounting depreciation. Under the Nigeria Tax Act 2025 they are computed on a straight-line basis, so the same percentage of cost is claimed each year; the initial allowance that used to give a large first-year deduction has been abolished.
The annual rates depend on the class of qualifying expenditure: 10% (class 1, for example buildings, masts and agricultural assets), 20% (class 2, for example plant, equipment and furniture) and 25% (class 3, other qualifying expenditure such as software).
Only expenditure on which value added tax or import levies have been paid qualifies, a notional value of 1% of cost is retained until the asset is disposed of. The allowance is pro-rated if part of the company’s income is not taxable. Rates and rules change, so check the current Act in an examination that sets its own conventions: always follow the rates and method stated in the question.
Example. A machine costs ₦40m and is in class 2 (20% a year on cost): the allowance is ₦8m for four years; in year 5 it is ₦7.6m, which leaves ₦0.4m (1%) as the retained value. At a tax rate of 30% the tax saving is ₦2.4m a year (8 × 30%) and ₦2.28m in year 5.
If the machine is sold at the end of year 5 for ₦6m, the balancing charge is ₦6m − ₦0.4m = ₦5.6m, which costs tax of ₦5.6m × 30% = ₦1.68m.
Where a question uses the older reducing balance method, the allowance is a percentage of the tax value left each year. A ₦40m asset at 25% reducing balance gives allowances of ₦10m, ₦7.5m (25% of 30), ₦5.625m and ₦4.22m, leaving a tax value of ₦12.66m after four years; on disposal the difference between proceeds and the remaining tax value is the balancing charge or allowance.
An after-tax NPV
The machine above is bought for ₦40m and earns a pre-tax cash flow of ₦15m a year for 5 years, then is sold for ₦6m. Tax is 30%, paid one year in arrears; the cost of capital is 12%.
| Year | Item | Cash flow ₦m | Factor 12% | present value (PV) ₦m |
|---|---|---|---|---|
| 0 | Machine | (40.0) | 1.000 | (40.00) |
| 1 | Operating cash flow | 15.0 | 0.893 | 13.40 |
| 2 | 15.0 less tax on year 1: 30% × (15 − 8) = 2.1 | 12.9 | 0.797 | 10.28 |
| 3 | 15.0 less tax of 2.1 | 12.9 | 0.712 | 9.19 |
| 4 | 15.0 less tax of 2.1 | 12.9 | 0.636 | 8.20 |
| 5 | 15.0 less tax of 2.1, plus sale 6.0 | 18.9 | 0.567 | 10.72 |
| 6 | Tax on year 5: 30% × (15 − 7.6) + 1.68 = 3.9 | (3.9) | 0.507 | (1.98) |
| NPV after tax | 9.80 | |||
The after-tax NPV is +₦9.80m. Before tax it would have been 15 × 3.605 + 6 × 0.567 − 40 = +₦17.48m, so tax reduces the value of the project but it is still worth accepting. Without capital allowances the tax would have been higher still, so the allowance schedule is a significant part of the value.
The ideas in more depth
Why allowances matter though depreciation does not
Depreciation is a book entry that never involves cash. A capital allowance is a rule in the tax law that reduces the tax the company pays, so it changes the cash the company has. The same asset therefore has two different “depreciations”: one for the accounts, ignored, and one for tax, included through its tax effect.
Why the abolition of the initial allowance matters
An initial allowance gave a large deduction at the start, so the tax saving arrived early, when it is worth most. With straight-line allowances only, the saving is spread over the life, so its present value is lower and the NPV of capital-intensive projects falls. This is why the reform affects the timing of investment in asset-heavy industries.
Sources and references
- The Nigeria Tax Act 2025, effective 1 January 2026, for the company tax rate and capital allowances (section 27 and the schedules); the Nigeria Tax Administration Act 2025 for payment dates.
These points are stated as at 5 November 2026.
Worked examples
Example 1: an allowance. A ₦40m machine, class 2 at 20% on cost; tax 30%. Required: the annual tax saving.
- Allowance.
20% × ₦40m = ₦8m. - Saving.
30% × ₦8m = ₦2.4m a year.
Example 2: tax on the profit. Operating cash flow ₦15m; allowance ₦8m; tax 30%. Required: the tax.
- Taxable profit.
15 − 8 = ₦7m. - Tax.
30% × 7 = ₦2.1m.
Example 3: disposal. Sale proceeds ₦6m; retained value ₦0.4m; tax 30%. Required: the tax on disposal.
- Balancing charge.
6 − 0.4 = ₦5.6m. - Tax.
30% × 5.6 = ₦1.68m.
How to answer in the exam
- State the tax rate, the allowance method and the timing that you apply, and follow the question where it differs from the current law.
- Compute the tax each year on cash profit less allowance, in a separate working.
- Time each tax payment in the year it is paid, including the last payment after the project ends.
- Keep interest out of the cash flows and use an after-tax cost of capital.
Common mistakes in the exam
- Deducting accounting depreciation instead of the capital allowance.
- Taxing the cash flow without deducting the allowance first.
- Forgetting the last year of tax after the project has ended.
- Forgetting the balancing charge or allowance on disposal.
- Putting interest in the cash flows.
- Applying the allowance to the sale proceeds instead of the cost.
Quick revision
- Tax = rate × (cash profit − allowance); allowance saving = allowance × rate.
- Nigeria Tax Act 2025: straight-line allowances at 10%, 20%, 25% by class; no initial allowance.
- Balancing charge = proceeds − retained tax value.
- Interest through the after-tax cost of capital; tax timed as paid.
Practice questions
These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.
Recall check: multiple choice
Question 1. In appraisal, depreciation is:
- Included as a cash flow
- Deducted from the discount rate
- Replaced by capital allowances for the tax calculation and ignored as a cash flow
- Always tax free
Show the answer
C. It is a book entry, not cash.
Question 2. The tax saving from a capital allowance is:
- Allowance ÷ tax rate
- Allowance × tax rate
- Cost × tax rate
- Allowance + tax rate
Show the answer
B. It reduces the tax payable by that amount.
Question 3. Under the Nigeria Tax Act 2025, the initial allowance is:
- Abolished
- Doubled
- Unchanged
- Optional
Show the answer
A. Only straight-line annual allowances remain.
Question 4. The annual allowance rate for class 2 (plant and equipment) is:
- 10%
- 50%
- 5%
- 20%
Show the answer
D. Class 1 is 10% and class 3 is 25%.
Question 5. Interest on borrowings is treated by:
- Deducting it from cash flows
- Using an after-tax cost of capital
- Adding it to the cash flows
- Ignoring tax relief
Show the answer
B. It is in the discount rate.
Question 6. If tax is paid one year in arrears, tax on year 1 profit is placed in:
- Year 2
- Year 0
- Year 1
- Year 5
Show the answer
A. The year of payment.
Question 7. A balancing charge arises when an asset is sold for:
- Less than its tax value
- Its cost
- More than its tax value
- Nothing
Show the answer
C. The excess is taxable.
Question 8. Debt costing 14% before tax at a tax rate of 30% costs after tax:
- 14%
- 4.2%
- 16.8%
- 9.8%
Show the answer
D. 14% × 0.70.
Question 9. The tax effect of delaying a payment by a year is to:
- Raise its present value
- Lower the present value of tax paid
- Remove it
- Double it
Show the answer
B. Later payments are discounted more.
Question 10. The company tax rate for large companies in the Act is:
- 30%
- 7.5%
- 4%
- 0%
Show the answer
A. Small companies are exempt.
Section B style: written questions
Question 11 (10 marks). (a) State why depreciation is ignored but capital allowances are included. (4 marks) (b) State how interest is treated. (3 marks) (c) State the effect of abolishing the initial allowance. (3 marks)
Question 12 (15 marks). A machine costs ₦20m, in class 2 (20% on cost). Tax is 30%, paid in the year of the profit; the cost of capital is 12% (annuity factor for 5 years 3.605). (a) Calculate the annual allowance. (3 marks) (b) Calculate the annual tax saving. (3 marks) (c) Calculate the present value of the savings over five years. (4 marks) (d) State the effect on the NPV. (5 marks)
A further written question
Question 13 (20 marks). A machine costs ₦30m, in class 2 (20% on cost, with 1% retained). It gives a pre-tax cash flow of ₦11m a year for 5 years and is sold for ₦3m at the end of year 5. Tax is 30%, paid one year in arrears; the cost of capital is 12% (factors 0.893, 0.797, 0.712, 0.636, 0.567, 0.507).
(a) Calculate the annual allowances. (4 marks) (b) Calculate the tax each year, including the balancing charge. (6 marks) (c) Prepare the cash flows for years 0 to 6. (4 marks) (d) Calculate the NPV. (6 marks)
Model answers
Show the model answer to Question 11
(a) Depreciation is a non-cash accounting entry and does not change the cash the company pays or receives (2). Capital allowances reduce the tax payable, which is a real cash saving (2).
(b) Interest is not put in the cash flows (1.5); the financing cost and its tax relief are in the after-tax cost of capital (1.5).
(c) The tax relief is spread over the life instead of being front-loaded (1.5), so its present value is lower and the NPV of capital-intensive projects falls (1.5).
Show the model answer to Question 12
(a) 20% × ₦20m = ₦4m (3).
(b) 30% × ₦4m = ₦1.2m (3).
(c) 1.2 × 3.605 = ₦4.33m (4).
(d) The allowances add ₦4.33m to the present value of the project, so they raise the NPV by that amount compared with having no tax relief on the cost (5).
Show the model answer to Question 13
(a)
- 20% × ₦30m = ₦6m in years 1 to 4
- year 5: 30 − 24 − 0.3 = ₦5.7m (4).
(b)
- Years 1 to 4: 30% × (11 − 6) = ₦1.5m each.
- Year 5: 30% × (11 − 5.7) = 1.59 plus balancing charge 30% × (3 − 0.3) = 0.81, a total of ₦2.40m (6).
(c) Year 0 −30; year 1 +11; years 2 to 4 11 − 1.5 = +9.5; year 5 9.5 + 3 = +12.5; year 6 −2.4 (4).
(d)
- PVs.
9.82 + 7.57 + 6.76 + 6.04 + 7.09 − 1.22 = 36.07 - NPV = 36.07 − 30 = +₦6.07m (6).
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