This decision is clearly based on assumptions, owing to the incomplete nature of the information available: i) that the investment is a single cash flow, ii) tax is too difficult, so keep it simple and avoid capital allowances, iii) inflation in the discount factor will be constant over the project life, and iv) when the project ends, there will be no terminal cash flows.
When it comes to investment appraisals we are happy to make broad assumptions. But when it comes to pricing, will our customers be equally happy to assume? If not, what are the implications for the pricing experts in the finance function?
The following example is based on a subsidiary of a large utilities company. The subsidiary invested [pounds sterling]1bn to provide new facilities and expand capacity. Commercial contracts deemed that part of the investment was to be recovered from customers at a post-tax real rate of return of, say, six per cent over the life of the contract. Excel was initially used as a price calculation tool. A process improvement project team then reviewed this and established how it would be improved.
The recoverable investment comprised 13 different assets, each with unique project start dates and cash outflows to suppliers. Because the investment takes place in multiple phases, and new customers are joining for different contract durations in each phase, the need to share asset usage over that duration posed a particular problem. This meant that each period of asset use could have three to five customers sharing the asset, with each customer having a share of the asset capacity.
The largest of the recoverable assets cost [pounds sterling]18m and took three years to construct. For the purpose of a present value calculation the accuracy required in a pricing context dictated that the monthly cash flows be captured.
[FIGURE 1 OMITTED]
Calculating monthly discount rates
The nominal discount rate is the sum of 1/ [(RPI(n) / RPI [degrees]) * (PTROR A M)], where:
* RPI(n) is the retail price index actual or forecast for the month of calculation.
* RPI [degrees] is the retail price index in the month of the first project cash flow.
* (M) is the month number from the month of the first project cash flow.
* PTROR is the post-tax real rate of return per month or l+6%A(l/2).
The taxation treatment of the investment arises from the capital allowance rules, which replace depreciation in the calculation of taxable profits. The sum of the annual amount invested by asset is a capital allowances asset that is written off on a reducing balance basis (main pool WDA 20 per cent 2010- 11). Each year's capital allowance, multiplied by the prevailing rate of corporation tax, is the value of tax saved (the company was chargeable). *
Customers had been paying for use of the assets on a monthly basis in arrears. To account for payments made before the pricing revision, each payment was discounted from the asset start date to give the PV of payments received. The tax outflow resulting from the payments received was calculated at the prevailing rate of corporation tax.
[FIGURE 2 OMITTED]
In a similar way to a mortgage, any delays in making due payments resulted in the accumulation of interest. This meant that the outstanding principle, at a point in time, was repayable in equal, real-terms monthly payments over the remaining contract term. However, while this met the contractual need to achieve the real terms rate of return, inflation was then added to future payments so as to achieve the rule. Bear in mind that mortgage payments have a flat profile in nominal terms, while these payments were …