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There is this ongoing issue with Fixed Costs, well not really ongoing but how BPP solved the problem below is bit confusing to me.
BPP Practice and Revision Kit ( Mock Exam 2, Q1). It is an International Investment Appraisal question. One of the information said and i quote
“Fixed Costs and local variable costs, which for the first year of operation are 12 million pesos and 600 pesos per unit respectively, are expected to increase by the previous year’s rate of inflation”.
My interpretaion from the above means both costs are to increase ? so fixed costs will increase?
BUT the answer only uses variable costs and ignored fixed costs.
Please any explanation why this was the case or should I just state my own assumptions in the exam and work with that. I know.
Feedback s are highly appreciated. I just need to pass this P4 this time
I do not have the BPP mock, but the reason will almost certainly be because fixed costs are only relevant if the total fixed costs increase as a result of doing the project. For profit purposes they may well absorb them over different projects, but for DCF we are only interested if the total fixed costs change.
That makes sense then, so only incremental fixed cost because of the project and not because of general inflation, Thanks
Can any one provide me solution of paper strategic financial management 3.7 of december 2006 of ACCA………?
Please forum/Tutor, can someone help me with the correct treatment of tax allowable depreciation.
In some solutions, it forms part of the cashflows before tax and after the tax is calculated, it is added back to the After tax cashflow.
However in Some other answers, what is done is this. They calculate the capital allowance and get the tax effect on the allowance calculated and this is added to the cashflows after tax and if it is a balancing charge the effect is a deduction. So which is the correct treatment
You can do it either way – both give the same net cash flow.
I prefer the second way (as you will have seen in my lecture) it is easier and safer.
Thanks a lot, that was very helpful John
If the question said that the Fixed Overheads will grow from year one at a rate of 10%. What will be our charges to put into the NPV calculations?
Will it be:
i) yr 1= 20
yr 2= 42
or will it be incremental changes
ii) yr1 = 20
If the fixed overheads are 20 in the first year and grow at 10% per year each year, then they will be 22 in the second year, and so on……..your answer (ii).
I don’t know why you have called them incremental changes at all. There would be no logic whatsoever in your answer (i)
(Just suppose you personally pay rent of 20 a year, and I tell you it will increase at 10% a year – it will not mean you pay 42 next year!!!!)
Separately though, do remember that fixed overheads are only relevant at all if they are extra (incremental) fixed overheads as a result of doing the project. If they are going to be payable anyway then they are not relevant.
Do we always claim unrecovered allownance on the balance left in the pool? and consequently the tax benefit on it?
We cannot deal with a pool in P4 questions, and so we treat as a special item and have a balancing charge or balancing allowance if it is sold.
If the assets are not sold by the end of project, then what will we do with the balancing amount?
It really depends on assumptions, and whether or not you are told the value of the project at the end of the planning period. Sometimes the examiner has treated the value at the end as if they were sale proceeds (and therefore had a balancing charge/allowance), other times it has just been reducing balance for each year of the planning period. On at least one occasion the problem has been avoided by the question giving the after-tax value, which assumed it had dealt with all taxes.
If it is not made clear then state your assumption and you will get the marks. In P4 there is rarely one correct answer – it depends often on assumptions made (not just with regard to tax).
So will we calculate any charge or allowance if ‘it has just been treated as reducing balance for each year of the planning period’?
That is not what I wrote.
You will always have capital allowances during the appraisal period at reducing balance!
I’m not getting you. I’m asking, if at the end of a project for e.g 6th year, after charging capital allowance that year, if there still remains some balance and no sale proceeds are given, so will we calculate any unrecovered allowance on it by multiplying with the tax rate?
The way capital allowances work is this:
Every year it is a writing down allowance of 25% reducing balance except for the final year.
In the final year, there is no writing down allowance. Instead you subtract any sale proceeds from the written down value and the difference is a balancing allowance or a balancing charge – that is the capital allowance in the final year.
And if no sales proceeds are given then what will we do?
With regards this tutorial, why is it that no tax benefit is associated with the asset in the year it is disposed? I would have expected a tax benefit of 570 *0.25*0.25 (balance at end of year 4 x charge for year 5 x tax effect of charge for year 5). Please assist!
this i mean before we make a determination of whether there should be a balancing allowance or charge and the tax effect thereof.
No – the only tax effect when a non-current asset is sold is the tax on the balancing charge or allowance (as is in the lecture).
(Ignore this bit if it confuses, but the point is that you are allowed to get a total tax saving of 25% (the tax rate) of the total drop in value of the asset – in this case it drops in value by 800 (1800 cost less 1000 sale proceeds) and so the total tax saving will be 25% x 800 = 200. However, year by year you get the saving on a reducing balance basis, and then in the final year there is the balancing charge or allowance which makes the overall total tax saving equal to the 200. If you add up all the tax benefits over the years, then it does come to a total of 200 (subject to roundings))
Thanks. I get this. What I don’t understand is why there was no capital allowance in the year of disposal. Is the disposal presumed to occur at the start of the year? If so should we not do away with revenues and costs in the year of disposal? The calculation of the balancing charge clearly assumes there is no capital allowance in the year of disposal and I want to understand why this assumption is made. I hope clarifies my question.
The rule for the capital allowance calculation is that it is 25% reducing year for every year except the final year. In the final year there is either a balancing allowance or a balancing charge depending on the amount of the sale proceeds. It has nothing to do with when the asset is sold during the year.
(A balancing allowance is a capital allowance, a balancing charge is simply a negative allowance)
(That is the rule, although in fact even if it was allowed to have 25% in the final year it would end up with the same result – all that would happen is that the balancing charge or allowance would change, but the net result would be exactly the same )
Thanks John, I see what you mean.
Consider this. $US/Sterling
3 Months Forward 1.9066-1.9120
1 year Forward 1.8901-1.8945
Sterling up to 6 months 5.5% 4.2%
Dollar up to 6 months 4.0% 2.0%
We need to pay $1,150,000 in 5 months time, What will be the interest rate for borrow an equivalent pound now for.
I don’t know what you mean by ‘equivalent’ pound.
However the interest rate for borrowing pounds is 5.5% per year, and so the interest for 5 months borrowing will be 5/12 x 5.5%.
I actually mean the interest rate for borrowing pounds, The interest rate of 5.5% is for up to 6 months, Which according to the answer was 0.08333 which I don’t know how they got it.
Either you have misread the answer or there is a typing error.
The interest rate for depositing dollars for 5 months is 5/12 x 2% which equals 0.833% (or 0.00833).
The interest rate for borrowing pounds is 5/12 x 5.5% which is 2.29% (or 0.0229)
Thanks Sir, I think it must be a typing error, The question is actually from Kaplan revision Kit. Qn No 20 (LAMMER Plc)
Informative and a good revision run.
Thanks for the lectures, I have one question to ask, Its from December 2008 Exams Question one (BLIPTON), I real don’t know how Project operating cash flow (Nominal) is calculated at the return Phase.
I guess you are clear as to how the real cash flows have been calculated – these are the cash flows ignoring inflation. (If you are not clear about any of them then do post again).
The nominal cash flows are the actual cash flows – i.e. taking account of the inflation (which in the UK is 2.5% per annum.
So…….the first cash flow is $52,000 in real terms, but this is received 2 years after the start of the project and so we need to add on 2 years inflation. 52,000 x (1.025^2) = 54,633
Similarly, the second cash flow is 490,000 in real terms, but is received at time 3 and so we need three years inflation at 2.5% per annum. 490,000 x (1.025^3) = 527676
And so on
Thanks you very much sir, I will always remain thankful to you
sir is there a lecture on adjusted present value ???
Yes – it is covered in chapter 12 of the course notes. On the index of lectures it is chapter 11 – the impact of financing.
thankx alot sir
@toobaalvi in as close to a lay man explanation as i can, i understand or treat so i understand working capital to mean its like pettycash. ie you already have taxable income from your sales, and you are told you need to have a buffer cash set aside for incidentals and is readily availed towards the project hence you would have already paid the tax for the same money when you received it as revenue etc. or from the source you raised it with.
The Tutor will answer both of us with a better answer, it just helps me to think of it that way!
To be honest it does not matter how you think about it provided that you accept that there will be no tax implications, and that (unless you are told otherwise) you will get it all back at the end of the project.
(Although it is not really petty cash – it is money to finance extra receivables and extra inventory. These would not affect the tax liability, and at the end of the project you no longer need to finance extra receivables etc and so you get the money back )
dear sir whatis difference between ACCA and FIA
Foundations in Accountancy are a series of exams set by the ACCA that give certificates in basic accounting.
The ACCA Qualification is a full professional accounting qualification for which you have to take 14 examinations.
You can find full details of both on the ACCA website http://www.accaglobal.com
@Cara you meant for Accounting rate of return, thats when you need taxable profit and all. However the Tutor will correct me if iam wrong, it seems P4 (atleast from what i have covered to date assumes that to be carry forward knowledge hence it does not cover that revision, but that does not mean its irrelevant to do it .
2. I also wanted to make an observation on the 20% Fixed Overheads, that statement can be confusing in the exam, i know by now we understand irrelevant vis a vis relevant costs in decision making, and that it then means whether this project is embarked on or not the company will still pay the $1000,000. But once the question says ‘should be absorbed ‘ it tends to imply they arise because of the project and could have been avoided etc. (thats the confusion to watch out for)
The other one is for tax (Payed immediately or one year later ! the later one implies we add for the above example another year 6! as for the (Current prices of inflation! this information are a must to watch out for in the exam!) especially during the reading hours highlight them and scribble what effect they should have e.g whether you start the inflation in year 1 or after year 1.
Otherwise it would indeed be a welcome gift to get such a straight forward question in an exam setting!
See my answer to Caro below
thanks this helps a lot.
@Cara i remember thats what my lecture also said for F9 i think then we used to get instances where we had to do an accounting rate of return or something, The syllabus i have covered for P4 i havent seen it touched as a method to use in evaluating investments, In any case when explained we have been mostly made aware of its shortcomings as a basis for appraisal method for a projects. as compared to NPV and IRR.
Admin, I missed the part on why we are not using the 20% Fixed Overheads, i do remember from my previous study though that certain costs are irrelevant in decision making because whether you take on the project or not you still incur them. So is the same logic applied here?!
2. I will practice more examples i have noticed if ever we get an easy question like this one we would be lucky in the exam as the examiner seems to enjoy confusing us by throwing in all concepts in one question esp the compulsory section. Sometimes i really feel, what is important is really not the numbers but understanding the concept enough to apply it in real life situations. As this type of questions can just take too much of the exam time! in future the answer sheets should have the templates in advance! Whew.
Hey. I’m anna confirm a single logic. hy orking capital has no tax consequences.?
Simply a good start of NPV revision
may i know the timing we should start to claim capital allowance?
from my understanding, if we incurred capital expenditure in year 0, we should claim capital allowance in year 1 unless the question state otherwise. But, should i apply the same concept if first year allowance is given in the question?
time 0 is not a year – it is a point in time.
If you watch the lecture it makes it clear (and if necessary watch the relevant F9 lectures).
However, in P4 do not worry too much about the timing – it depends on assumptions (as does so much of P4). If you state your assumptions then you will get the marks (provided obviously that they are sensible assumptions )
can we tear out the formula sheet, the present value table and the annuity table during the exam time, so that its earsier for us to see the rate and save up time,no need to flip the question booklet many times.
I suggest you send this question to the ACCA… and please post on opentuition the reply from them thanks!
thank you for this lecture , again very well explained I have one question in relation to NPV. I just looked in my notes from F9, and my lecturer then ask us in calculation of NPV first include capital allowances in calculation of taxable profit than calculate and deduct tax and than add capital allowances back. So the tax effect is at the end the same as in NPV which you presented. I remember that my lecturer justified this approach because taxable profit which include capital allowances was needed in the calculation of something else, and well I don’t remember now where did we use it. Could you please tell me where we we can use such a profit, and if it will be used in the calculation in P4
For F9 it does not matter which way you deal with the capital allowances. The answer will be the same whichever way.
For P4, the same usually applies. The only thing at P4 is that in one question it was the case that if there was a taxable loss, then it was made clear that you could not offset it against other profits (and therefore not simply get a tax saving) but that the losses were carried forward.
However, to be honest it is best you leave worries about that until P4 – for F9 it does not matter which way you do it. Whichever way you find the easiest to remember
So will it be wrong to include fixed overhead ????
@springy, see what I have written below in reply to somebody else.
Fixed overheads are only relevant if the total changes as a result of doing the new project.
incemental fixed cost(project related)
step fixed cost
are relent costs….
thanks a good revision of NPV
In the NPV (e.g 1) question we inflated the sales and costs at different inflation rates, which essentially mean that we considered the nominal cash flows. In that case, aren’t we supposed to consider the nominal rate as well which is the real rate inflated at the general inflation?
@Ruzz Su, Yes – certainly.
However, the nominal cost of capital is the actual cost of capital. Since all the question says is that the cost of capital is 10% we must assume that it is the actual (i.e. nominal) cost of capital. We would always assume this unless we were specifically told the ‘real’ cost of capital.
(Additionally, since the question does not give the general rate of inflation, the again we have to assume that the cost of capital given is the actual WACC i.e. the nominal rate.)
Thanks very much for your help.
Fixed overheads are only relevant if the total fixed overheads for the company increase.
If the questions simply says that some of the overheads are allocated to the project, it does not mean that the total expenditure changes.
(The point is that for profit purposes a company change split the overheads between projects any way that they want to, but again, the total cash flow for the company only changes if the total fixed overhead bill changes.)
hi please can you just confirm why we didnt take into account of fixed overhead cost?
@osru, Listen from 13.18 to 13.50
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