1. In investment appraisal calculations, I have a problem with using capital allowances since i am confused about the timing of the capital allowances and the tax benefits they generate.  Can you help me?
Capital allowances or tax-allowable depreciation give a company the benefit of tax relief on the cost of buying non-current assets. The profit on which tax is calculated is reduced by the amount of the capital allowance, so the tax liability is reduced by an amount equal to the capital allowance multiplied by the tax rate.

The simplest approach to dealing with capital allowances in investment appraisal is to claim one capital allowance for each year of operation of an investment project. The first capital allowance is claimed in the first year, reducing the tax liability for that year. If tax is paid in the year in which the liability arises, the tax paid in the first year will be lower. If tax is paid one year in arrears, the tax paid in the second year, which is the tax due on the first year's profits, will be lower. The exam question will state whether tax is to be paid one year in arrears. This approach assumes that the non-current asset, say a machine, was bought at the start of the first year of operation.

A more complicated approach to dealing with capital allowances in investment appraisal is to assume that the machine is bought before the first year of operation. This assumption is closer to what happens in reality, but it makes investment appraisal more difficult. The first capital allowance is claimed against company profits (not project profits) in the year before the investment project begins. One capital allowance will also be claimed for each year of operation, so there will be one more capital allowance than in the first method. If tax is paid in the year in which the liability arises, the first tax payment will be made at the start of the project (Year 0) and there will be one tax payment in each year of the project. If tax is paid one year in arrears, there will be one tax payment in each year of the project and one tax payment after the project has ended.

I recommend the first approach, which is easier to understand and leads to fewer errors when answering examination questions. This also the approach adopted by the suggested answers to examination questions.

2. Can you explain how shareholders benefit financially from owning shares in a company?
Many companies pay dividends to their shareholders, so each year shareholders receive cash income from the shares they own. Shareholders also hope that the price of their shares on the stock market will increase during the year. This increase in share prices is a capital gain. Unless the shares are sold at the end of the year, the capital gain will be an unrealised gain, i.e. a gain on paper but not in cash terms.

The wealth of a shareholder is increased by both the dividends received and the capital gain. The sum of these, compared to the share price at the start of the year, is called total shareholder return. In percentage terms, total shareholder return is the sum of dividend yield and percentage capital gain. It represents the actual return on shares and compared with the theoretical return on shares, for example the return predicted by the capital asset pricing model.

3. I often confuse ARR and IRR.  Can you explain the difference between these two investment appraisal methods?
I think confusion arises because accounting rate of return (ARR) and internal rate of return (IRR) have the same letters in their acronyms. Both investment appraisal methods give a value in percentage terms, but there the similarity ends.

IRR is the discount rate which gives a net present value of zero for an investment project. The IRR method is a discounted cash flow method that takes account of the time value of money and the calculated IRR is found by linear interpolation. The ARR method uses average annual accounting profit, not cash flow, and calculates a percentage return on the capital invested in a project. ARR is very similar to return on capital employed (ROCE) and the two terms (ARR and ROCE) are often used interchangeably from an investment appraisal point of view. Once you gain an understanding of how different these two methods are, it will become difficult to confuse them.