Hi, My question is the following,
You mentioned that NPV assumes the life of the project let’s say is x years and as it can be more or less we treat it as a disadvantage for NPV. However in the textbook it is treated as an advantage for NPV and Disadvantage for ROCE. Can you please elaborate on this as I believe this may come as an MSQ.

I said that a problem with our decision to accept the project based on the NPV being positive is that all the cash flows and the project life and the cost of capital are all estimates. That is not saying it is a disadvantage at all because I also say that equally using ROCE is based on estimates also. (Saying that there could be a problem with our decision is not the same as saying that there is a disadvantage with the method!)

Your book cannot possibly have said that it was an advantage either. What it almost certainly will have said is that NPV takes account of the timing of the cash flows, whereas ROCE does not (it just takes an average).

The main advantage of NPV is that it is looking at cash flows and the timing of the flows. This is important because it is the level of cash that determines the dividends that can be paid. A problem with ROCE is that it is based on profits and profits can be manipulated and profits are not the same as the cash available for dividends and for further investment.

Again, I make all these points in the course of the lectures.

I am not able to understand why we discount our cashflows ??
is it only because the value of money decreases with time due to inflation or what other factors cause us to discount a future inflow or outflows ?
and what causes inflation ??
please help.

The reason for discounting is not because of inflation. It is purely to account for the fact that if money is invested in a project then it costs interest – the money used has to be borrowed and there will be interest payable. Even if the company already has the cash, thr shareholders are entitled to have the cash as dividend and by using it to finance the project they are effectively borrowing it from shareholders.
If you are still unsure then do watch the Paper F2 lectures on investment appraisal where this is explained (and ‘proved’).

Thank you sir, ur answer did explain it but i ll watch F2 lecture because i need to learn it in depth. thank u for the prompt reply.
your lectures really simplify everything.

At the end of the video you mention getting the cash flows can be difficult, I am currently attempting a question in which the cash flows are not given and you must sort out the relevant and irrelevant information. You are only given a profit projection table, I was wondering if you could point me in the right direction or if you can link me to a video that might help me as I am having no luck finding one.

I am very surprised that you could not find a lecture!

The next chapter in the free Lecture Notes (which you need if you are watching the lectures) is called ‘Relevant cash flows for DCF’ and if you look at the listing of lectures there are 5 lectures on this chapter – all called ‘relevant cash flows’ going through the examples in the notes and bringing in ultimately all of the different problems that can arise.

Hello sir,
I am still a lil stumped when it comes to timing of the tax benefits. Could you please tell me if I am right with respect to the following?
1) If the machine is bought on the first day of t0 and tax is paid a year in arrears, then the first Capital Allowance (CA) benefit accrues in t2
2) If the machine is bought on the last day of t0 and tax is paid a year in arrears, the the CA benefit occurs in t1
What if the machine is bought on the first day of t0 and tax is paid in the same year?! Will the CA be part of t0 cash flows?
And what if the machine is bought on the last day of t0 and tax is paid in the same year? When will the CA benefits accrue?
This is one area that has been troubling me!
Will be indebted if you could sort this out!
Thanks a ton, and YOU ARE AMAZING!!!

t0 is a point in time – not a year. You mean year 0, year 1 etc.

1) If the machine is bought on the first day of t0 and tax is paid a year in arrears, then the first Capital Allowance (CA) benefit accrues in t2
2) If the machine is bought on the last day of an accounting period and tax is paid a year in arrears, the the CA benefit occurs at time 1

If the machine is bought on the first day of an accounting period and tax is paid in the same year the CA benefit occurs at time 1 (the CAs are not calculated until the end of the year, which is in 1 years time)

If the machine is bought on the last day of an accounting period and tax is paid in the same year the CA benefit occurs at time 0.

So sir, if the machine has a life of 4 years, and it is bought on the last day of the accounting year, and tax is paid in a year in arrears, why do we consider 5 years of tax benefit?!
Could you please elaborate situations in which we will consider an extra year of CA benefit?
Thanks

If you buy on the last day of an accounting period, then you get capital allowances for that year and for each of the four years that you are using it.

However it is unlikely that you will ever have this situation except in a lease and buy question

So,
If an asset has a life of 4 years, is bought on the first day of the year, and tax is paid in a year in arrears, then we will consider tax benefits from the years y2-y5.

If it has a life of 4 years, is bought on the last day of the year, tax is paid in arrears, then tax benefits accrue from y1-y5

If it has a life of 4 years, is bought on the first day of the year, tax is paid in the same year, then CA benefit accrues from y1-y4

If it has a life of 4 years, is bought on the last day of the year, tax is paid in the same year, then CA benefit accrues from y0-y4
Am I right?
Please sort this out! Thanks a lot in advance!

T0, T1 etc are points in time that are one year apart. The only need for them is because we need to account for the interest in yearly intervals when we discount.

Suppose our year end is 31 December each year, and suppose the initial investment is on 1 January 2012.

Then time 0 is 1.1.2012.

31.12.2012 is time 1 (because it is one year later – we are not worried about one day for interest purposes).

1.1 2013 is also time 1 (again it is one year later and we are not worried about one day).

Mr Moffat
I was trying to do Guestion 9 Ballet plc from the practice questions. I would like to know for a question like this how will i know that the increased costs production starts in the first year and also why the capital allowances start in year 0. I would also like to know why was tax not calculated but instead full capital allowances and tax savings were included.
Thank you

The question says that currently production is 10,000 tonnes but that it is growing at 5% p.a.. This implies that next year (i.e. year 1 in the appraisal) the production will be 5% higher (and then 5% higher again in year 2 and so on).

The writing down allowance is only there as part of workings (to calculate the tax saving) – it has not been included in calculating the net cash flow. So, for example, the net cash flow at time 1 is 0.250 – 0.050 – 0.315 + 0.083 = (0.032)
Tax has been calculated – but as in my lectures it has been calculated in two parts – the tax on the operating flows (at time 2, 0.315 x 33% = 0.104); and the tax saved on the capital allowances (at time 1, 0.250 x 33% = 0.083).

Finally, the question says that the machine will be in working order immediately prior to the next financial year. This implies that it was bought in the current financial year, and so capital allowances will be given now – time 0 – and the benefit of the tax saving will be one year later i.e. at time 1.

Lilit says

Hi, My question is the following,

You mentioned that NPV assumes the life of the project let’s say is x years and as it can be more or less we treat it as a disadvantage for NPV. However in the textbook it is treated as an advantage for NPV and Disadvantage for ROCE. Can you please elaborate on this as I believe this may come as an MSQ.

John Moffat says

I certainly did not say that at all!

I said that a problem with our decision to accept the project based on the NPV being positive is that all the cash flows and the project life and the cost of capital are all estimates. That is not saying it is a disadvantage at all because I also say that equally using ROCE is based on estimates also. (Saying that there could be a problem with our decision is not the same as saying that there is a disadvantage with the method!)

Your book cannot possibly have said that it was an advantage either. What it almost certainly will have said is that NPV takes account of the timing of the cash flows, whereas ROCE does not (it just takes an average).

The main advantage of NPV is that it is looking at cash flows and the timing of the flows. This is important because it is the level of cash that determines the dividends that can be paid. A problem with ROCE is that it is based on profits and profits can be manipulated and profits are not the same as the cash available for dividends and for further investment.

Again, I make all these points in the course of the lectures.

Lilit says

Thank you for clarification, I reread the text!!!!!! Understood

mburhan says

Hi Sir,

I am not able to understand why we discount our cashflows ??

is it only because the value of money decreases with time due to inflation or what other factors cause us to discount a future inflow or outflows ?

and what causes inflation ??

please help.

John Moffat says

The reason for discounting is not because of inflation. It is purely to account for the fact that if money is invested in a project then it costs interest – the money used has to be borrowed and there will be interest payable. Even if the company already has the cash, thr shareholders are entitled to have the cash as dividend and by using it to finance the project they are effectively borrowing it from shareholders.

If you are still unsure then do watch the Paper F2 lectures on investment appraisal where this is explained (and ‘proved’).

mburhan says

Thank you sir, ur answer did explain it but i ll watch F2 lecture because i need to learn it in depth. thank u for the prompt reply.

your lectures really simplify everything.

brianh92 says

Hello Sir,

At the end of the video you mention getting the cash flows can be difficult, I am currently attempting a question in which the cash flows are not given and you must sort out the relevant and irrelevant information. You are only given a profit projection table, I was wondering if you could point me in the right direction or if you can link me to a video that might help me as I am having no luck finding one.

Kind Regards

Brian

John Moffat says

I am very surprised that you could not find a lecture!

The next chapter in the free Lecture Notes (which you need if you are watching the lectures) is called ‘Relevant cash flows for DCF’ and if you look at the listing of lectures there are 5 lectures on this chapter – all called ‘relevant cash flows’ going through the examples in the notes and bringing in ultimately all of the different problems that can arise.

chandhini says

Hello sir,

I am still a lil stumped when it comes to timing of the tax benefits. Could you please tell me if I am right with respect to the following?

1) If the machine is bought on the first day of t0 and tax is paid a year in arrears, then the first Capital Allowance (CA) benefit accrues in t2

2) If the machine is bought on the last day of t0 and tax is paid a year in arrears, the the CA benefit occurs in t1

What if the machine is bought on the first day of t0 and tax is paid in the same year?! Will the CA be part of t0 cash flows?

And what if the machine is bought on the last day of t0 and tax is paid in the same year? When will the CA benefits accrue?

This is one area that has been troubling me!

Will be indebted if you could sort this out!

Thanks a ton, and YOU ARE AMAZING!!!

John Moffat says

t0 is a point in time – not a year. You mean year 0, year 1 etc.

1) If the machine is bought on the first day of t0 and tax is paid a year in arrears, then the first Capital Allowance (CA) benefit accrues in t2

2) If the machine is bought on the last day of an accounting period and tax is paid a year in arrears, the the CA benefit occurs at time 1

If the machine is bought on the first day of an accounting period and tax is paid in the same year the CA benefit occurs at time 1 (the CAs are not calculated until the end of the year, which is in 1 years time)

If the machine is bought on the last day of an accounting period and tax is paid in the same year the CA benefit occurs at time 0.

chandhini says

Oops! Yeah, my mistake! Thanks for clarifying!

You Rock, Sir! I am a huge fan of yours!! 😀

chandhini says

So sir, if the machine has a life of 4 years, and it is bought on the last day of the accounting year, and tax is paid in a year in arrears, why do we consider 5 years of tax benefit?!

Could you please elaborate situations in which we will consider an extra year of CA benefit?

Thanks

John Moffat says

If you buy on the last day of an accounting period, then you get capital allowances for that year and for each of the four years that you are using it.

However it is unlikely that you will ever have this situation except in a lease and buy question

chandhini says

So,

If an asset has a life of 4 years, is bought on the first day of the year, and tax is paid in a year in arrears, then we will consider tax benefits from the years y2-y5.

If it has a life of 4 years, is bought on the last day of the year, tax is paid in arrears, then tax benefits accrue from y1-y5

If it has a life of 4 years, is bought on the first day of the year, tax is paid in the same year, then CA benefit accrues from y1-y4

If it has a life of 4 years, is bought on the last day of the year, tax is paid in the same year, then CA benefit accrues from y0-y4

Am I right?

Please sort this out! Thanks a lot in advance!

John Moffat says

Yes – that is all correct.

Ivan says

May I ask you a question regarding the timing?

If we are talking abount Y0 and Y1, Is Y0 and Y1 would be the same as a point of beginning and ending the period?

Say Y0 is 01 Jan 2015 or Y0 is 31 Dec 2014

Y1 is 31 Dec 2015? Y1 is 31 Dec 2015?

Which one is correct?

Ivan says

So is Y0 first point of the Year 1 period or

Y0 is a last point of a prior period to Year 1?

John Moffat says

T0, T1 etc are points in time that are one year apart. The only need for them is because we need to account for the interest in yearly intervals when we discount.

Suppose our year end is 31 December each year, and suppose the initial investment is on 1 January 2012.

Then time 0 is 1.1.2012.

31.12.2012 is time 1 (because it is one year later – we are not worried about one day for interest purposes).

1.1 2013 is also time 1 (again it is one year later and we are not worried about one day).

31.12.2013 is time 2

1.1.2014 is time 2

31.12.2014 is time 3

1.1.2015 is time 3.

and so on

Ivan says

Thank you very much. Now it is clear. I really appretiate that you reply for my numerous questions Sir!

John Moffat says

You are welcome

tdcc says

Mr Moffat

I was trying to do Guestion 9 Ballet plc from the practice questions. I would like to know for a question like this how will i know that the increased costs production starts in the first year and also why the capital allowances start in year 0. I would also like to know why was tax not calculated but instead full capital allowances and tax savings were included.

Thank you

tdcc says

I also cannot figure out how the net cash flows were arrived at.

John Moffat says

The question says that currently production is 10,000 tonnes but that it is growing at 5% p.a.. This implies that next year (i.e. year 1 in the appraisal) the production will be 5% higher (and then 5% higher again in year 2 and so on).

The writing down allowance is only there as part of workings (to calculate the tax saving) – it has not been included in calculating the net cash flow. So, for example, the net cash flow at time 1 is 0.250 – 0.050 – 0.315 + 0.083 = (0.032)

Tax has been calculated – but as in my lectures it has been calculated in two parts – the tax on the operating flows (at time 2, 0.315 x 33% = 0.104); and the tax saved on the capital allowances (at time 1, 0.250 x 33% = 0.083).

Finally, the question says that the machine will be in working order immediately prior to the next financial year. This implies that it was bought in the current financial year, and so capital allowances will be given now – time 0 – and the benefit of the tax saving will be one year later i.e. at time 1.

tdcc says

Thank you sir. That was a big help.

John Moffat says

You are welcome

fahim231 says

why is the scrap value discounted?

i thought this was added on at the end?

John Moffat says

The scrap is received at the end of the projects life and so it needs discounting to bring it back to an equivalent amount ‘now’ (i.e. at time 0)