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How do you do capital investment appraisal?

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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).

In the Finance Bill 2013 it was announced that for 2 years from 1st January 2013 the Annual Investment Allowance will be increased from £25,000 to £250,000 (an increase of 10 times!).

 

This is fantastic news if you are planning asset purchases because it will reduce your tax bill.

Some examples of AIA qualifying expenditure

 

‘Plant or machinery’ actually covers almost every sort of asset a person may buy for the purposes of his/her business. Really the only business assets not covered are land, buildings and cars (which are excluded by one of the ‘general exclusions’). Typical examples of plant or machinery include:

– computers and all kinds of office furniture and equipment
– vans, lorries, trucks, cranes and diggers
– ‘integral features’ of a building or structure, see CA22320
– other building fixtures, such as shop fittings, kitchen and bathroom fittings
– all kinds of business machines, such as printing presses, lathes and tooling machines
– tractors, combine harvesters and other agricultural machinery
– gaming machines, amusement park rides
– computerised /computer aided machinery, including robotic machines
– wind turbines and fibre optic cabling.

Capital Allowances

Capital allowances are available to sole traders, self-employed persons or partnerships, as well as companies and organisations liable for Corporation Tax.

If you buy an asset, for example, a car, tools, machinery or other equipment for use in your business, you cannot deduct your expenditure on that asset from your trading profits. Instead, you may be able to claim a capital allowance for that expenditure if you haven’t claimed the Annual Investment Allowance for the same asset.

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

steve@bicknells.net


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