Business Studies – 6.1.2 Effects of government policy | e-Consult

Introduction: Investment decisions are heavily influenced by profitability and the cost of capital. Corporation tax is a significant component of a company's overall cost structure and therefore impacts the profitability of investment projects. This answer will explore how changes in corporation tax can influence a company's decision to invest in new machinery, considering different scenarios.

Scenario 1: Corporation Tax Reduction

• Increased Profitability: A reduction in corporation tax increases the after-tax profit from investment projects. This makes investment projects more attractive, as they are more likely to generate a positive return.
• Improved Return on Investment (ROI): Higher after-tax profits improve the ROI of investment projects, making them more appealing to investors and lenders.
• Increased Investment Appetite: The company is more likely to approve and fund new machinery investments, leading to increased productivity and competitiveness.

Scenario 2: Corporation Tax Increase

• Reduced Profitability: An increase in corporation tax reduces the after-tax profit from investment projects. This makes investment projects less attractive.
• Lower ROI: Lower after-tax profits reduce the ROI of investment projects, making them less appealing to investors and lenders.
• Delayed or Cancelled Investments: The company may delay or cancel planned investments in new machinery, particularly if the expected ROI is not high enough to justify the investment after tax.
• Increased Cost of Capital: The company may need to offer a higher rate of return to investors to compensate for the higher tax burden, increasing the cost of capital and making investment projects less viable.

Scenario 3: Corporation Tax Remains the Same

• Investment Decision Based on Other Factors: If corporation tax remains unchanged, the company will likely base its investment decision on other factors such as the projected return on investment, the company's cash flow, and the overall economic outlook.
• Sensitivity Analysis: The company will still consider the impact of corporation tax on profitability, but it will be less of a determining factor than in the other scenarios.

Conclusion: Changes in corporation tax have a significant impact on investment decisions. A reduction in corporation tax generally encourages investment, while an increase discourages it. Companies carefully weigh the after-tax profitability of investment projects when making decisions about capital expenditure.