I have a question about Salvage Value taxation.
The curriculum, nor Schweser really gives me any clear explanation why Salvage Value can be taxed in two different ways:
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In the case of calculating NPV and a project’s final cashflow, we see that the Salvage Value - Book Value, is taxed in order to calculate the terminal cashflow. The tax over the gain/loss is deducted/added.
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In the explanation of ‘Other inncome measures and Valuation models’, the curriculum show how to calculate Accounting Income, with a drilldown of the steps to end up at each year’s total after tax cash flow.
I would expect the final year’s After Tax Cashflow to have the same components. But here not the gain/loss of Salvage Value - Book Value is taxed, but the whole Salvage value. Which gives a lower cashflow. Why is the treatment different? What is the difference?
Why is this different?
It’s different because you are doing a totally different assessment in each case (1. & 2.).
In (1.) you are valuating a specific project, not necessarily a whole company. For example, the replace of an old machine, buying trucks for product distribution instead of using courier, etc. This projects consider assets of limited life (machine, trucks, etc) so they are expected to be sold in the future (at the end of the project). As accounting considers book value of these assets (at whatever method: accelerated depreciation, straight, double-declining balance, economic, etc), at the moment of the asset sale, depreciation and liquidation price won’t necessarily match, so a gain or loss will be added to Income Statement, thus taxed.
In (2.) “other income measures and valuation models” are used to value a whole company, to value equity or a firm. This is totally different because you are not only valuing part of a company, but all the assets inside, all the opportunities in sight of the company brought to present and collapsed in a single number: share price. This is the reason each year cash flow considers its own tax adjustment and an ending value of _ the company. _ This ending value can be calculated using various methods like multiplier ratio (EBITDA x, Cash Flow x, Comparable x, etc). Another important point that perhaps is not clear at all is that in (1.) you are valuing a project with a limited time life, whereas in (2.) we are valuing a company assuming infinite time life (going concern assumption).
Hope this helps!