Question

A company is planning an investment of 5,000,000 today.
The investment is depreciated on a straight-line basis over the life of 5 years and the residual value at the end of the project is assumed to be 500,000.
The investment will generate the following income over the next five years: 4,000,000, 4,500,000, 5,000,000, 5,500,000 and 6,000,000.
Payable operating expenses (operating expenses excluding depreciation) will amount to 60% of the income in the individual year.
The annual working capital requirement is assumed to be 10% of the following year's turnover.
The project will be part-financed with a serial loan (repaid with equal annual installments over the project's lifetime) of 5,000,000 at an interest rate of 2% pa.
The project's tax rate is 20%.

If we use the equity method, what is tax calculated in year 3?

Answer 1

SOLUTION :-

Particulars	Year 3
​​​​​​Income	5,000,000
Less : Operating Expenses (W.N. 1)	(3,000,000)
Less : Depreciation (W.N. 2)	(900,000)
Less : Interest on loan (W.N. 3)	(60,000)
Profit before Tax	1,040,000
Tax Rate (20%)	(208,000)
Profit after Tax	832,000

The tax calculated in year 3 under equity method is $208,000.

​​​Working Note 1 :-

Operating Expenses is accounted 60% of the income in the individual year,

5,000,000 × 60% = 3,000,000

Working Note 2 :-

Depreciation is recorded on Straight Line Method

Depreciation Amount = (Total value of investment - Residual Value) ÷ No.of years

= (5,000,000 - 500,000) ÷ 5

= 900,000

Working Note 3 :-

Interest on Loan in year 3 will be after paying two equal installments of 1,000,000. The interest of Year 3 shall be on the remaining 3,000,000 × 2% = 60,000.

Note :-  Since we are calculating the taxable profit by deducting expenses from the income, effect of working capital will be ignored while calculating the profit before tax.