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The question states:
Annual depreciation on NCA is 10% and this is the amount of investment needed to maintain the current level of activity.So, the only effect on FCF should be tax relief on depreciation (assumed this is tax depreciation).
However the answer assummes that CAPEX is zero and deducts depreciation from the PBT to be used for FCF estimatiin. This is NOT correct.
Please clarify.
It IS correct.
Although depreciation is not a cash flow and is therefore ignored, investment to maintain the level of activity is a cash flow.
So although depreciation itself should be added back, the payment to maintain the level of activity should be subtracted – there is zero net effect which is why he does not bother adding back and then subtracting the same amount.It is something that the current examiner assumes often.
Well, the question from ACCA website states:
“Annual depreciation on non-current assets is 10% and this is the amount of investment needed to maintain the current level of activity.”
=> “Depn = CAPEX” – that’s how I understand this!
The calculation per answer:
Estimating value of new company after buy-out $m
Profits before depreciation 50
** Depreciation ((1/3 x $100m + $50m) x 10%) (8.3)
Tax (20%) (8.3)
** Cash flows before interest payment 33.4** It is assumed that the depreciation is available on the re-valued non-current assets plus the new investment. It is assumed that no additional investment in non-current assets or working capital is needed, even though cash flows are increasing.
So, by the phrase “no additional investments in NCA or WC is needed”, the examiner means that no CAPEX other than, so-called, the “Depreciation CAPEX” is required. So, CAPEX=Depn which is OK. Am I correct?
Consequently, the depreciation shown above includes actually:
“CAPEX – less tax relief on depreciation”
Am I correct?If I’m correct, the answer is rather tricky 🙂
Thank you in advance.
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