Investment decisions in fixed assets or capital expenditure are very critical and crucial for the company. One good decision may groom the company and one bad decision may broom the company. Different methods of valuation are available for decision making purpose and they are accounting rate of return method, payback period method, net present value method and internal rate of return method. The most widely used method is the net present value method when two mutually exclusive options are to be considered, as in this case. The other methods can not be used for the drawbacks in them, the accounting rate of return method doe not consider the time value of money and cash flow as it is based on profit of the business. Payback period completely ignores the cash flow after payback period over the useful life of the project and also ignores the time value of money. Therefore under the net present value method both cash flow over the life of the project is considered and also the time value of money is considered. Actually, net present value is calculated by determining present value of cash inflows and then comparing with the cost of the project. If the present value of inflows is going to exceed the project cost it is going to be accepted otherwise not. And if there are two options involve the option with higher positive net present value is going to be accepted. It may also be applied if two options are not mutually exclusive after determining NPV index or profitability index, the option with higher index is preferred. In calculating present value cash flow and discount rate are the most important. The cash flow form project can be without tax deduction and with tax deduction. The tax rate and cash flow after tax may change the decision making activity regarding the option. It is very apparent in the case of Dr. Dunn; the project seems to be accepted without tax as follows:

With no tax / Cash flows / D.F. .15 / PV
Model A
0 / -120000 / 1 / -120000
1 / 40000 / 0.86957 / 34783
2 / 40000 / 0.75614 / 30246
3 / 40000 / 0.65752 / 26301
4 / 40000 / 0.57175 / 22870
5 / 40000 / 0.49718 / 19887
14086 / NPV
Pay back period
120000/40000 / 3 / years
With no tax / Cash flows / D.F. .15 / PV
Model B
0 / -110000 / 1 / -110000
1 / 32000 / 0.86957 / 27826
2 / 32000 / 0.75614 / 24197
3 / 32000 / 0.65752 / 21041
4 / 32000 / 0.57175 / 18296
5 / 32000 / 0.49718 / 15910
-2731 / NPV
Pay back period
110000/32000 / 3.4375 / years

It is quite apparent that the Model A is acceptable with higher positive net present value and it is also meeting the target payback period of the company. However the payback is irrelevant in this type of decision making.

But when the tax rate of 40% is applied to cash benefits from operation, the position is entirely different, as follows:

With tax / Cash flows / D.F. .15 / PV
Model A
0 / -120000 / 1 / -120000
1 / 33600 / 0.86957 / 29217
2 / 33600 / 0.75614 / 25406
3 / 33600 / 0.65752 / 22093
4 / 33600 / 0.57175 / 19211
5 / 33600 / 0.49718 / 16705
-7368 / NPV
cash flow after tax / 40000-24000-6400 =9600+24000 = 33600
Pay back period
120000/33600 / 3.571429 / years
With no tax / Cash flows / D.F. .15 / PV
Model B
0 / -110000 / 1 / -110000
1 / 28000 / 0.86957 / 24348
2 / 28000 / 0.75614 / 21172
3 / 28000 / 0.65752 / 18410
4 / 28000 / 0.57175 / 16009
5 / 28000 / 0.49718 / 13921
-16140 / NPV
cash flow after tax / 32000-22000-4000 = 6000+22000=28000
Pay back period
110000/28000 / 3.928571 / years

Now you can see that the both options are not acceptable with negative net present value and payback period of both projects are more than the company’s target payback period. However if the selection is a must position then still the Model A is preferable due to its lower negative net present value.

It may be concluded that the tax rate changes the cash flow of the options and also the net present value, but there is no change in the decision, as in both cases, with tax and without tax, the model A is acceptable.