The question says that 20% of overheads are absorbed (charged) to the new project, but this does not mean that the total overheads increase. We are only interested in any extra cash flows as a result of doing the project, so if the total overheads do not change then there is no extra cash flow.

But why? Although there will be a general rate of inflation in a country, that is only an average – not everything will inflate at the same rate. Think about oil prices – sometimes they go up more than other goods – sometimes the go up less than other goods.

My question is if the net operating flow was a loss, i.e. a negative value (401) in the first year how would we deal with the tax on operating flows and in tax savings on capital allowances for the next year?

We always assume (in Paper F9) that the company is already making profits from other projects and is therefore already paying tax.

Therefore if the operating flows from this project are negative then it will save tax (because the total profit of the business will be lower).

So we deal with the tax on operating profits in exactly the same way as always – if there is a positive operating flow then there is a tax outflow; if there is a negative operating flow then there is a tax inflow.

Capital allowances are not affected – the tax savings on them will be the same whatever happens.

If the are extra (incremental) overheads payable by the company as a result of doing the project, then it is a relevant cash outflow (of the extra amount) when getting the net cash flows each year.

Why is the material cost 864 in the first year and not 800? Wouldnt you buy the material on day one so therefore there would be no inflation in a day hence why Im confused why we do not use 800.

The lecture is saying if we do buy the machine it would be next year that we would buy the material, but if we decide to go ahead with the project and buy the machine tomorrow then wouldnt we then buy the material tomorrow aswell so therefore no inflation?

We assume that the price increases on the first day of each new year. It may be impractical, but that is the assumption we make.
Also, the term “current prices” automatically always means in the exam that in one year it will inflate by one year, two years inflation in two years time, etc..

You would ignore it because it is not a cash flow.
(Depreciation is always ignored. Capital allowances are only considered because of the affect on the tax.)

Have you watched the previous lectures, because I spend time on the timing of the cash flows in them.

It is not ‘year 0’ it is time 0, which is a point in time. Time 0 is ‘now – the start of the first year. Time 1 is one year from now – the end of the first year / start of the second year, and so on.

We always assume that operating cash flows occur at the ends of year (unless told differently in the question), so although we will be buying materials throughout the first year, we assume that the cash flow occurs at then end of the first year i.e. at time 1.

yes, i have watched the previous lecture. i got your point now, i have figure out the where i have made a mess, the mess was on different between time0 and year o. you made it very clear now. thank you so much for your kind reply. its so nice of u . thumbs up…:)

in the NPV calculation, for discount factor calculation what do we use if we have given only real cost of capital 5.7%

inflation is 5%

do we use the formula (1+nominal rate)=(1+real rate)x(1+inflation rate), i used this formula but still does not give a round % to use for discount factor.

ivan says

hello

in this example 4 chapter 8 i got a question.

why in the cash flow you did not include the 20% from the overheads?

John Moffat says

I do actually explain in the lecture.

The question says that 20% of overheads are absorbed (charged) to the new project, but this does not mean that the total overheads increase. We are only interested in any extra cash flows as a result of doing the project, so if the total overheads do not change then there is no extra cash flow.

Jens says

Dear John,

I am a little confused that the inflation rate for labour is different than the one for material. Should the rate not be equal for the same period?

Kind regards

Jens

John Moffat says

But why? Although there will be a general rate of inflation in a country, that is only an average – not everything will inflate at the same rate. Think about oil prices – sometimes they go up more than other goods – sometimes the go up less than other goods.

Sali says

Great lecture Sir.

My question is if the net operating flow was a loss, i.e. a negative value (401) in the first year how would we deal with the tax on operating flows and in tax savings on capital allowances for the next year?

Thanks in advance.

SALI

John Moffat says

We always assume (in Paper F9) that the company is already making profits from other projects and is therefore already paying tax.

Therefore if the operating flows from this project are negative then it will save tax (because the total profit of the business will be lower).

So we deal with the tax on operating profits in exactly the same way as always – if there is a positive operating flow then there is a tax outflow; if there is a negative operating flow then there is a tax inflow.

Capital allowances are not affected – the tax savings on them will be the same whatever happens.

Sali says

I got it. Thanks Sir.?

John Moffat says

You are welcome 🙂

mehreen245 says

sir what do we need to do if we got extra overheads relevant to this project

John Moffat says

If the are extra (incremental) overheads payable by the company as a result of doing the project, then it is a relevant cash outflow (of the extra amount) when getting the net cash flows each year.

Paul says

hello,

Why is the material cost 864 in the first year and not 800? Wouldnt you buy the material on day one so therefore there would be no inflation in a day hence why Im confused why we do not use 800.

The lecture is saying if we do buy the machine it would be next year that we would buy the material, but if we decide to go ahead with the project and buy the machine tomorrow then wouldnt we then buy the material tomorrow aswell so therefore no inflation?

John Moffat says

We assume that the price increases on the first day of each new year. It may be impractical, but that is the assumption we make.

Also, the term “current prices” automatically always means in the exam that in one year it will inflate by one year, two years inflation in two years time, etc..

fahim231 says

what would you do with depreciation if there was no capital allowances?

John Moffat says

You would ignore it because it is not a cash flow.

(Depreciation is always ignored. Capital allowances are only considered because of the affect on the tax.)

fahim231 says

so say for example the question said depreciation is absorbed into the fixed costs, would you have to take away depreciation from the fixed costs?

John Moffat says

Yes – you would. We are only concerned with cash flows and depreciation is not a cash flow.

arman90fy says

Hello sir

one things i am confuse about is , if we dont buy the material now on year 0, then how we gonna produce the product to sale on year 1?

John Moffat says

Have you watched the previous lectures, because I spend time on the timing of the cash flows in them.

It is not ‘year 0’ it is time 0, which is a point in time. Time 0 is ‘now – the start of the first year. Time 1 is one year from now – the end of the first year / start of the second year, and so on.

We always assume that operating cash flows occur at the ends of year (unless told differently in the question), so although we will be buying materials throughout the first year, we assume that the cash flow occurs at then end of the first year i.e. at time 1.

arman90fy says

yes, i have watched the previous lecture. i got your point now, i have figure out the where i have made a mess, the mess was on different between time0 and year o. you made it very clear now. thank you so much for your kind reply. its so nice of u . thumbs up…:)

zubeyde says

in the NPV calculation, for discount factor calculation what do we use if we have given only real cost of capital 5.7%

inflation is 5%

do we use the formula (1+nominal rate)=(1+real rate)x(1+inflation rate), i used this formula but still does not give a round % to use for discount factor.

Thank you

John Moffat says

In that case you would discount using the nearest % – the examiner expects you to use tables rather than calculate the discount factors exactly.

However it is very unusual to be asked to use real rates. Usually we inflate the flows and then discount at the actual cost of capital

zubeyde says

Thank you so much

Asheem says

Thank you John for this beautiful Lecture.