Working capital is money needed to finance having to accept higher receivables, higher inventories etc..

Therefore it is likely that there will be extra outflows of cash to cover this during the life of the project.

At the end of the project we assume that we no longer need extra receivables etc. and so the money is released – we get back all of the working capital previously invested.

The relevant free lectures for Paper F9 on relevant cash flows for investment appraisal will help you – P4 is exactly the same as F9 in this respect.

Sir i dint understand why you ignored the fixed cost and yet the management accountant decided that 20% of $1000 should be absorbed into the new product.

Absorbing means charging. For profit purposes fixed overheads can be charged to different products any way we want. However for DCF we are only interested in extra cash flows incurred by the company. Simply deciding to split the overheads differently does not mean that the total fixed overheads of the company will change. If the total does not change then there is no additional cash flow.

It may help you to watch the Paper F9 lectures on this.

I just got little bit confused regarding two things, please correct me if am wrong

a) In the example 1 above, was it assumed the materials were bought at the end of 1st year, such that they were inflated upto end of 1st year? If this is so how come there were sales at the year one, does this mean all sales occured at the year end?

b) Regarding gearing, can we say that gearing is unsystematic risk, because it is company specific it may vary between different companies and because of this there is no need to include in beta, can we assume it may be eliminated by diversification?

In future, I will be grateful if you can ask this sort of question in the Ask the Tutor Forum rather than as a comment on a lecture

In answer to (a):

The production costs are quoted at current prices. The rule is that if costs are quoted at current prices then the cost in 1 years time will be higher because of inflation.
The logic behind this is that if you are thinking of buying this new machine, then you are likely to get quotes regarding the cost of materials etc now (even though you have not yet bought the machine). However, you will not be actually incurring the cost until next year and so by next year the cost quoted (at current prices) will have increased because of inflation.
With regard to the selling price, the question specifically says that they will be sold at $20 per unit in the first year, and so it is only in later years that the cash price will be increased.

In answer to (b):
Gearing is not unsystematic risk. The effect of gearing it to increase the existing risk of the business, whether it be systematic or unsystematic. If the earnings were certain (so no risk) then gearing would have no effect on the risk to shareholders because the dividends would be certain also. Obviously in practice, the earnings are subject to risk (both systematic and unsystematic) and the affect of gearing is to increase the level of risk when it comes to dividends (and therefore for shareholders).

If I am not making this clear, then you will find it helpful to watch the F9 lecture on gearing risk where I go through an example to explain exactly how gearing increases the existing risk in the business.

I really appreciate for your quick response Mr Moffat, i now got the concept very clearly. I apologize for the mistake regarding posting questions in the comments section rather than posting it in the Ask the Tutor Forum.
Thanks once again.

I don’t understand your question (this place is for commenting on the lecture – if you have a specific question then you should ask it in the Ask the Tutor Forum).

What about the answers?
They are on the ACCA website.

Again in calculating discount factors, well if you want to calculate the discount factor of year 2 to infinity at a cost of capital of 14%, you take the perpetuity of 7.143 multiplied by the DF of year 2 of 0.769 to get 5.493, correct me of I’m wrong.

Now when it comes to let’s say FCFE growing at 3% from year 4 to infinity then calculating the DF you take 1/(14%-3%)*DF of year 3, well my question is why not multiplying by the DF of year 4? Please explain to me the logic I’m getting confused.

To the same question if there was no growth rate and FCFE remained constant yeah i knw we wouldnt b deducting the growth rate but what would be the discount factor to the same scenario?

You are wrong (and I explained this to you a week ago – below)

For 2 to infinity you take the discount factor for a perpetetuity and multiply by the one year factor because it starts 1 year late (it starts at time 2 instead of time 1).

For 4 to infinity you take the discount factor for 1 to infinity and multiply by the 3 year discount factor because it starts 3 years late (it starts at time 4 instead of time 1)

What are the different ways of calculating the discount factor of, for example, year 3-15 at a cost of capital of 11%?
I tried taking the annuity of year 1-15 then subtracted the annuity of year 1-2, is this method acceptable?
Another method I tried was taking the annuity of year 1-15 then multiplied with the present value discount factor of year 2, correct me if I’m wrong.
Thank you.

Either method is acceptable.
However, you have made a mistake in your second method. If it is 3 to 15, then there are 13 years of flows. Therefore you should take the annuity factor for 13 years and then multiply by the present value factor for 2 years.

Both methods will give the same answer (apart from rounding, which is irrelevant in the exam).

You look up 0.7 down the left hand side, and then 0.07 across the top.

This should give you 0.2794.

Then you apply the rule at the bottom of the tables.
Here, because D1 is >0, you add 0.5 to the figure from the tables.
so N(D1) = 0.5 + 0.2794 = 0.7794

Sir is Business valuation covered in the audio lectures . And if yes , please guide me where to find them . And secondly post acquisition change is share price and the premium calculations , please guide me where to find them in your audio lectures.
Thank you.

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.

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

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.

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).

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?

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.

rowetigere says

Please help me understand the treatment of working capital.especially on the part were u said it has to be released

John Moffat says

Working capital is money needed to finance having to accept higher receivables, higher inventories etc..

Therefore it is likely that there will be extra outflows of cash to cover this during the life of the project.

At the end of the project we assume that we no longer need extra receivables etc. and so the money is released – we get back all of the working capital previously invested.

The relevant free lectures for Paper F9 on relevant cash flows for investment appraisal will help you – P4 is exactly the same as F9 in this respect.

rowetigere says

Thank you very much sir

ireengonwe says

Sir i dint understand why you ignored the fixed cost and yet the management accountant decided that 20% of $1000 should be absorbed into the new product.

John Moffat says

Absorbing means charging. For profit purposes fixed overheads can be charged to different products any way we want. However for DCF we are only interested in extra cash flows incurred by the company. Simply deciding to split the overheads differently does not mean that the total fixed overheads of the company will change. If the total does not change then there is no additional cash flow.

It may help you to watch the Paper F9 lectures on this.

ireengonwe says

Thanks i have understand now that we only concentrate on the extra charge.

Samson says

How can i download the video lecture for P4?

John Moffat says

Lectures cannot be downloaded – they can only be watched online.

It is the only way that we can keep this website free of charge.

sogan0 says

Thank You for the lecture

SOUD SAEED says

Hello Sir,

I just got little bit confused regarding two things, please correct me if am wrong

a) In the example 1 above, was it assumed the materials were bought at the end of 1st year, such that they were inflated upto end of 1st year? If this is so how come there were sales at the year one, does this mean all sales occured at the year end?

b) Regarding gearing, can we say that gearing is unsystematic risk, because it is company specific it may vary between different companies and because of this there is no need to include in beta, can we assume it may be eliminated by diversification?

Thanks,

Soud Said.

John Moffat says

In future, I will be grateful if you can ask this sort of question in the Ask the Tutor Forum rather than as a comment on a lecture

In answer to (a):

The production costs are quoted at current prices. The rule is that if costs are quoted at current prices then the cost in 1 years time will be higher because of inflation.

The logic behind this is that if you are thinking of buying this new machine, then you are likely to get quotes regarding the cost of materials etc now (even though you have not yet bought the machine). However, you will not be actually incurring the cost until next year and so by next year the cost quoted (at current prices) will have increased because of inflation.

With regard to the selling price, the question specifically says that they will be sold at $20 per unit in the first year, and so it is only in later years that the cash price will be increased.

In answer to (b):

Gearing is not unsystematic risk. The effect of gearing it to increase the existing risk of the business, whether it be systematic or unsystematic. If the earnings were certain (so no risk) then gearing would have no effect on the risk to shareholders because the dividends would be certain also. Obviously in practice, the earnings are subject to risk (both systematic and unsystematic) and the affect of gearing is to increase the level of risk when it comes to dividends (and therefore for shareholders).

If I am not making this clear, then you will find it helpful to watch the F9 lecture on gearing risk where I go through an example to explain exactly how gearing increases the existing risk in the business.

SOUD SAEED says

I really appreciate for your quick response Mr Moffat, i now got the concept very clearly. I apologize for the mistake regarding posting questions in the comments section rather than posting it in the Ask the Tutor Forum.

Thanks once again.

Soud Said.

P4 says

Answers for P4 December 2014? (This attempt)

John Moffat says

I don’t understand your question (this place is for commenting on the lecture – if you have a specific question then you should ask it in the Ask the Tutor Forum).

What about the answers?

They are on the ACCA website.

Fatma says

Again in calculating discount factors, well if you want to calculate the discount factor of year 2 to infinity at a cost of capital of 14%, you take the perpetuity of 7.143 multiplied by the DF of year 2 of 0.769 to get 5.493, correct me of I’m wrong.

Now when it comes to let’s say FCFE growing at 3% from year 4 to infinity then calculating the DF you take 1/(14%-3%)*DF of year 3, well my question is why not multiplying by the DF of year 4? Please explain to me the logic I’m getting confused.

Fatma says

To the same question if there was no growth rate and FCFE remained constant yeah i knw we wouldnt b deducting the growth rate but what would be the discount factor to the same scenario?

Any assistance would highly be appreciated.

John Moffat says

To discount a growing FCFE you use the dividend growth formula from the formula sheet.

John Moffat says

You are wrong (and I explained this to you a week ago – below)

For 2 to infinity you take the discount factor for a perpetetuity and multiply by the one year factor because it starts 1 year late (it starts at time 2 instead of time 1).

For 4 to infinity you take the discount factor for 1 to infinity and multiply by the 3 year discount factor because it starts 3 years late (it starts at time 4 instead of time 1)

Fatma says

Thanks a lot sir. Well different books confused me but now i can clearly get the concept.

I also appreciate your fast response.

Fatma says

What are the different ways of calculating the discount factor of, for example, year 3-15 at a cost of capital of 11%?

I tried taking the annuity of year 1-15 then subtracted the annuity of year 1-2, is this method acceptable?

Another method I tried was taking the annuity of year 1-15 then multiplied with the present value discount factor of year 2, correct me if I’m wrong.

Thank you.

John Moffat says

Either method is acceptable.

However, you have made a mistake in your second method. If it is 3 to 15, then there are 13 years of flows. Therefore you should take the annuity factor for 13 years and then multiply by the present value factor for 2 years.

Both methods will give the same answer (apart from rounding, which is irrelevant in the exam).

Fatma says

Really much appreciate your help.

jidep2acca says

Hello Sir,

Could you help understand how to make use of the normal distribution table to get D1 N(0.77) and D2 N(0.63)…. Thank you.

John Moffat says

You look up 0.7 down the left hand side, and then 0.07 across the top.

This should give you 0.2794.

Then you apply the rule at the bottom of the tables.

Here, because D1 is >0, you add 0.5 to the figure from the tables.

so N(D1) = 0.5 + 0.2794 = 0.7794

It is the same procedure for N(D2)

shahnawaz says

Sir is Business valuation covered in the audio lectures . And if yes , please guide me where to find them . And secondly post acquisition change is share price and the premium calculations , please guide me where to find them in your audio lectures.

Thank you.

John Moffat says

No – there are no lectures on these chapters.

lakeside says

Dear All/Tutor,

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

Thanks

John Moffat says

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.

lakeside says

That makes sense then, so only incremental fixed cost because of the project and not because of general inflation, Thanks

ALI says

Can any one provide me solution of paper strategic financial management 3.7 of december 2006 of ACCA………?

lakeside says

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

Many Thanks

John Moffat says

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.

lakeside says

Thanks a lot, that was very helpful John

prateshramjohn says

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

yr3=66

yr4=93

yr5=122

or will it be incremental changes

ii) yr1 = 20

yr2=22

yr3=24

yr4=27

yr5=29

Thanks.

John Moffat says

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.

prateshramjohn says

thanks alot.

toobaalvi says

Do we always claim unrecovered allownance on the balance left in the pool? and consequently the tax benefit on it?

John Moffat says

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.

toobaalvi says

If the assets are not sold by the end of project, then what will we do with the balancing amount?

John Moffat says

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).

toobaalvi says

So will we calculate any charge or allowance if ‘it has just been treated as reducing balance for each year of the planning period’?

John Moffat says

That is not what I wrote.

You will always have capital allowances during the appraisal period at reducing balance!

toobaalvi says

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?

John Moffat says

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.

toobaalvi says

And if no sales proceeds are given then what will we do?