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FM Walkthrough: NPV with Tax and Inflation — Step by Step

ExpertMinds Editorial·3 June 2026·12 min read

A fully worked ACCA FM investment appraisal question incorporating tax-allowable depreciation, specific inflation rates on revenues and costs, and working capital recovery — the most common source of dropped marks in Section C.

Investment appraisal questions appear in every FM exam session. Section C allocates up to 20 marks to them — roughly 20% of the total paper. The examiner consistently reports that candidates drop marks on the same three areas: incorrect tax-allowable depreciation (TAD) timing, forgetting working capital recovery in the final year, and discounting real cash flows at a nominal rate. This walkthrough covers all three.

Key fact:Question type: Section C constructed response · 20 marks · recommended time: 36 minutes. Answer on screen using the spreadsheet tool or the word processor — show all workings for part marks.

Hartwell Co is evaluating a 4-year project requiring initial investment of $2,400,000 in machinery. The machinery has a residual value of $200,000 at the end of Year 4. Tax-allowable depreciation is 25% reducing balance. Revenue in Year 1 is $1,800,000, inflating at 4% per year. Variable costs in Year 1 are $720,000, inflating at 6% per year. Working capital of $180,000 is required from the start of the project and is recoverable in full at the end of Year 4. Corporation tax is 25%, payable in the same year as the cash flow. The nominal post-tax cost of capital is 11%. Calculate the NPV of the project and advise whether it should be accepted.

[14 marks]

Step 1 — Set Up the Timeline

Identify all cash flow types and their years

Year 0: machine outflow ($2,400,000) + working capital outflow ($180,000). Years 1–4: inflated revenues and variable costs. Years 1–4: TAD tax savings. Years 1–4: tax on operating profit. Year 4: residual value + working capital recovery. Draw the timeline before doing any arithmetic — this prevents missed cash flows.

Tip:Always lay out a column per year before calculating anything. In the FM CBE spreadsheet tool, set up Year 0 through Year 4 as columns and label each row. You will earn presentation marks and avoid sequencing errors.

Step 2 — Inflate Revenues and Variable Costs

Apply separate inflation rates to each cash flow

Revenue: Y1 $1,800,000 · Y2 $1,800,000 × 1.04 = $1,872,000 · Y3 $1,872,000 × 1.04 = $1,946,880 · Y4 $1,946,880 × 1.04 = $2,024,755. Variable costs: Y1 $720,000 · Y2 $720,000 × 1.06 = $763,200 · Y3 $763,200 × 1.06 = $808,992 · Y4 $808,992 × 1.06 = $857,531.

Watch out:Different inflation rates examiner trap: revenues and variable costs inflate at different rates. Do NOT apply a single blended rate. Apply 4% to revenues and 6% to costs separately in each year. Candidates who blend rates get the contribution wrong for every year and lose 4+ marks.

Step 3 — Tax-Allowable Depreciation (TAD)

Calculate the 25% reducing balance and tax savings

Opening value $2,400,000. Y1 TAD: $2,400,000 × 25% = $600,000 → tax saving $150,000. Closing Y1: $1,800,000. Y2 TAD: $450,000 → tax saving $112,500. Closing Y2: $1,350,000. Y3 TAD: $337,500 → tax saving $84,375. Closing Y3: $1,012,500. Y4 balancing allowance: $1,012,500 − $200,000 residual = $812,500 → tax saving $203,125.

Year	Written-down value ($)	TAD ($)	Tax saving @ 25% ($)
0	2,400,000	—	—
1	1,800,000	600,000	150,000
2	1,350,000	450,000	112,500
3	1,012,500	337,500	84,375
4 (balancing)	200,000 residual	812,500	203,125

Watch out:Balancing allowance trap: in Year 4, the allowance is the remaining book value MINUS residual proceeds ($1,012,500 − $200,000 = $812,500). Candidates who forget to deduct the residual value overstate the balancing allowance and its tax saving. The residual value is a separate cash inflow — do not double-count it.

Step 4 — Working Capital

Working capital: outflow at Year 0, recovery at Year 4

Year 0: ($180,000) outflow. Year 4: +$180,000 inflow (full recovery). Working capital is not a taxable cash flow — no tax adjustment needed. Include it as a separate row to avoid netting it against operating flows.

Watch out:Working capital recovery examiner trap: this is the single most frequently missed cash flow in FM exam answers. The examiner explicitly flags it in almost every session report. If the question states "recoverable in full at the end of the project", include it in Year 4. It is a real cash inflow — working capital tied up in inventory and receivables is released.

Step 5 — After-Tax Operating Cash Flows and Discount

Combine flows, apply tax, discount at 11%

Net operating cash flow (pre-tax) = Revenue − Variable costs each year. Tax on operating profit = net operating CF × 25% (payable same year per question). After-tax operating CF = net operating CF × (1 − 0.25) = × 0.75. Add TAD tax savings separately. Discount factors at 11%: Y1 0.901, Y2 0.812, Y3 0.731, Y4 0.659.

Year	After-tax op CF ($)	TAD saving ($)	WC ($)	Residual ($)	Net CF ($)	DF 11%	PV ($)
0	—	—	(180,000)	—	(2,580,000)	1.000	(2,580,000)
1	810,000	150,000	—	—	960,000	0.901	865,000
2	832,350	112,500	—	—	944,850	0.812	767,018
3	853,416	84,375	—	—	937,791	0.731	685,525
4	875,419	203,125	180,000	200,000	1,458,544	0.659	961,181

Step 6 — NPV and Recommendation

Sum the present values and advise

NPV = (2,580,000) + 865,000 + 767,018 + 685,525 + 961,181 = +$698,724. The NPV is positive. Hartwell Co should accept the project as it generates a positive net present value of $698,724, meaning it is expected to increase shareholder wealth in present value terms at the company's cost of capital of 11%.

Key fact:Always conclude with a recommendation in plain English. A valid NPV calculation without a recommendation loses the professional skills mark (typically 1 mark). State the NPV, state it is positive, and recommend acceptance. If NPV were negative, recommend rejection — do not hedge.

Tip:Real vs nominal trap: this question gives a nominal WACC (11%). The cash flows have been inflated to nominal terms (we applied the specific inflation rates). Therefore: use the nominal discount rate with nominal cash flows. If the question had given a real rate and asked you to use the Fisher formula, the approach differs. Never mix real and nominal.

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