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is it correct to discount cashflow by 1 years inflation (to deflate it) since working capital is required at start of the year yet other cashflows are assumed to start at the end of the year. WC at time zero would be 49000 (50960*1.04^-1 ). Help I am comfused as the examiner has not done so in the solution
That’s a good question, your way seems logical to me, although in their way the working capital is literally 7% of revenue.
Also the bit where they state “Liability to tax is reduced by capital allowances on machinery” would have caught me out. From their wording, I wouldn’t have thought to deduct off the working capital, before calculating tax payable.
With regard to the working capital, it is not correct to ‘deflate’ it.
The question specifically says that it is to be 7% of the revenue for the year.
(The logic is that with inflation we effectively assume that the selling price ‘jumps’ by 7% once a year (not that it increases gradually over the year). However, logic or no logic, if the examiner says it is to be 7% of the revenue, then so it is 🙂 )The wording of the capital allowance sentence was a little unusual, but should not really cause a problem. Capital allowances always reduce the taxable profits and hence the tax liability.
It has nothing to do with working capital – capital allowances are given on the cost of the non-current assets (in this case the machinery). Working capital does not have any tax effect.Sorry, when I said “working capital” in my last sentence before I meant to say “capital allowances”.
Regarding the capital allowances in this particular question, it seems to be different from the other NPV questions I’ve practised. In the other questions I’ve done, I work out the taxable cash flow (ignoring capital allowances for now), and then I deduct tax payable, and then add on the capital allowances. Had I had done it this way for this question I would have got a completely different answer (I think).
I wish they’d keep all the questions the same. I just know I’m going to get caught out in the exam!
No – you would get exactly the same answer (honestly 🙂 )
Remember that in this question they are straight line, not reducing balance.
I always keep the tax on the operating profit and the tax saving on allowances separate – I think it is easier, and safer.
Doh, I’ve just realized what I did wrong! I do keep my tax payable and capital allowances separate as you suggested, but I forgot to multiply the capital allowance by 30%. I do indeed get the same answer now!
🙂
Just as well that you made the mistake now!!! You will not make the same mistake in the real exam 🙂
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