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why could we not add back depreciation and then charge the tax payable of 30% on the cashflows? I calculated depreciation as 22,500 (i.e. 100,000 less 10,000 divide by 4 years) and tax payable on the cash flows as 6,750 (i.e. 22,500 multiplied by 30%)
On the section for lease, how did we get the tax saved as 10,500 and then slap the figure year number two (2)?
The first lease payment of 35,000 is at the start of the yr. At the end of the yr, why is there a tax saving on 35,000? Why does it appear on second yr?
I would be grateful for any help on this example. My mind is about to collapse!
But add back depreciation to what???
You are not told the earnings that will arise (and they would be irrelevant anyway because we are not appraising the project – we are deciding on the best way of financing. The earnings would be the same whichever way).The tax depreciation (or capital allowances) are not 22,500 a year. The question says that it is 25% reducing balance (which is the most likely situation in the exam as well).
With regard to the tax saving on the lease payments. The first lease payment is at the start of the year (i.e. time 0). The tax will be calculated at the end of the year, and then there is a 1 year delay in the tax. So it will be two years before we get the tax benefit – the first tax benefit will therefore be at time 2.
(It is only in lease/buy questions that there is this problem with the timing of the tax.)It really would help you to watch my free lecture on this where I go through the example and explain what is happening.
Thanks Mr Moffat. Depreciation does not fall under the definition of relevant costs i.e. as future, cash or incremental. The relevant costs under our consideration are the cost of new machine100,000; the future scrap of 10,000 and the incremental costs being the tax relief on capital allowances.
On the lease, the relevant costs are the cash outflows of 35,000, the incremental tax relief of 10,500. The tax relief relief arises as a result of 35,000 being an allowable deduction for tax purposes hence indicated as the opportunity costs.
I am so grateful for your response as these help clear my mind. Hope one day I will be able to honour all the lecturers on Open Tuition! 🙂
Finally for the past week, i have had problems with speed on internet. like yesterday, a lesson of 27mins for Chapter 21, CAPM and MM (part a) took close to two hours to watch. I wonder why now an issue with speed? Is it due to many students accessing Chap 21?
I know that depreciation is not a relevant cost, so I do not know why you are asking about it.
Tax allowable deprecation (or capital allowances) are relevant for the buy option because they get save tax, and that is what has been dealt with in the answer to the example.Yes – with leasing the whole lease payment is tax allowable and so there is a tax saving as a result. This is dealt with in the answer.
With regard to the speed, I can only guess that it is an issue with your internet connection. There is no speed problem on our servers.
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