Capital Budgeting-- Retrenchment Compensation

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Faiz Ahmed (Querist)
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31 August 2010 My question is in relation to NPV method of capital budgeting. Suppose Retrenchment compensation of Rs100000 is paid in the year of installation of machine. This compensation is deductible for tax. Assuming tax rate as 30%. Why tax saving of Rs30000 is provided next year of its payment in calculation of total PV of cash outflow??

Kindly reply with clear logic...

Thrissurkkaran Ishtan

Thrissurkkaran Ishtan (Expert)
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01 September 2010 Is Rs. 100,000 an year zero outflow?

Faiz Ahmed

Faiz Ahmed (Querist)
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01 September 2010 Yes its in zero year outflow

Thrissurkkaran Ishtan

Thrissurkkaran Ishtan (Expert)
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01 September 2010 In capital budgeting zero year cash flow occurs at the start of business. The first tax incidence occurs at the end of year 1 and subsequent at end of year 2. So even though, your cash outflow occurs in year zero the tax benefit (inflow) happens only at end of year 1. Year 0 is now and you get the tax benefit at end of year 1.

However, for every subsequent cash flows it is assumed to be happening at the end of every year (this is the difference you should note). So if there any expenditure incurred in year 1 or year 2, then the outflow (exps) and inflow (tax benefit) are expected to be happening at the same time and at the end of the year.

If your doubt is still not cleared, please revert.

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Faiz Ahmed

Faiz Ahmed (Querist)
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01 September 2010 Thnx for clarifying my doubt.

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