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FM Chapter 8 Questions – Relevant cash flows for DCF

 

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  1. Hi, in question 2, I dont understand why the cost of capital is converted into the real rate when it is clearly not stated in the question that 12% is the nominal rate. It only says that 12% is the cost of capital. Also isnt the formula for a growing perpetuity = CF * (1 ÷ (r – g))? Where did you get this new formula from?

  3. Hi Sir! In question 4, i can understand that Sunk cost and depreciation is not relevant cost but not really clear on “interest cost”. Why is it also not a relevant cost? if company need to do this project, it may need to borrow capital and interest cost I think it can be relevant?

    • We never bring interest into DCF calculations because the whole reason for discounting is to account for the cost of money (including interest). To bring interest into the cash flows would be accounting for it twice.

  5. Jessicawatridge: There was no reply because I do not always see comment posted here. Best is to ask in the ‘Ask the Tutor Forum’ because I do always see posts there and reply within 24 hours.

    The labour cost will indeed be paid whether or not they do the new project. However, think about this:
    Suppose the selling price is $20, the labour is $4, and the other variable costs (materials and overheads) are $3. The contribution is therefore $13.

    If the labour is moved to another job, then they will lose the revenue of $20. They will save the other variable costs of $3. The labour will still be paid. So they will lost 20 – 3 = $17, and this is the relevant cost. This is (and always is) the same as the contribution of $13 plus the labour of $4.

    • I too had a doubt in this question Sir.

      If I clearly remember in one of the questions (chapter 8- example1), we just took the opportunity cost in consideration as ignored the labour cost because it is gonna be same for either projects.

      Although including the labour cost makes more sense to me but then why we didn’t include in the example 1.

  6. In question 1 even if we accept the project or not any way we have to pay the labor cost of $10 per hour because they are already fully employed in another activity. So how does it become a relevant cost?

      • The question has been raised several times if you skim through the comments below (just search for “Question 1” in your search function). Should give you the answer.
        “To explain, just suppose the other work gives revenue of 50, labour cost is 10, and materials are 28. So contribution is 12.
        If labour is taken to use elsewhere then we lose the revenue of 50 but we no longer need to pay for materials of 28. (Labour is still paid for). So the net loss is 50 – 28 = 22, which is the same as contribution plus labour.”

      • I do not know who you are agreeing with, but what Dinariegels has written in the post immediately above yours is correct (as is the answer given in the test) 🙂

  8. I am confused by question 1.

    I thought from F5 & F9 that the only relevant cost is the lost contribution. If they are fully employed on a project and you are just moving them them the wages are not an extra cost, only the $12 per hour is because they are not doing that project. However if you replace them with new workers, then you will not be losing contribution of $12, therefore that won’t be relevant, only the $10 per hour would be.

    So i argue that both of the rates $10 & $12 cannot be relevant? What have I missed?

    • When labour is taken off a job, then the relevant cash flow is the lost contribution plus the labour cost. What you argue is wrong, and I explain this in my Paper PM lectures.

      If labour is taken off a job, then we lose the revenue from that work, and we save the variable costs from that work (except for the labour cost, which is paid anyway). Therefore the relevant cost is revenue less other variable costs, which is always the same as contribution plus labour.

  9. Hi Sir,
    Q2: Why “Because the flow is in perpetuity, you have to discount the real flows (i.e. the current price flows ignoring inflation) at the real cost of capital”?

    Q4: Which is not relevant to Discounted Cashflow Project Appraisal=> Why Depreciation is not relevant? I thought it’s relevant because the Depreciation affects the Tax allowance (which is also included in the concept of Discounted Cashflow Project Appraisal)?

    • Q2: I explain this in my lectures. Normally we inflate the cash flows to get the nominal cash flows and then discount at the actual/nominal cost of capital, but this is clearly not possible if it is a perpetuity – you would need a very long piece of paper to inflate the cash flows to get the nominal cash flows then it was for perpetuity!!!!

      Q4: Depreciation is not a cash flow and it therefore not directly relevant. Tax is of course a cash flow, and therefore is relevant – however it is calculated after the tax allowable depreciation (the capital allowances) which are not necessarily the same as the accounting depreciation.

  11. Thank you Tutor, I am requesting for your guidance and clarity again having read through your response to earlier comments.

    Would I be correct to say that the Lost Revenue is $22 i.e ({Revenue-Variable Cost includes Labour = Contribution} therefore Lost Revenue = $12+$10 = $22) and therefore this is what I would reflect in my Appraisal Statement/Calculation?

    Thank you Sir

    • Your figures are correct, but not your words 🙂

      We lose the revenue but save the other variable costs (excluding labour), so the net cost is revenue less other variable costs, which is always equal to lost contribution plus labour.

      • Hi John,

        could please confirm whether my understanding is right or wrong about the reason of excluding the labour cost when calculating contribution. is it because the labour cost is considered as fixed cost? if in other context, where labour cost is hourly based, would the labour cost be deducted from revenue when calculating the contribution?

      • If labour is being moved to the new contract from existing work, then the labour will still be being paid and so there is no change in the amount spent.

  12. Thank you Sir John for you clarification regarding William question … It is very clear now to me as well .. I had the same confusion as him when I take the test hours ago.

    Kind regards,
    Aissata

  13. Hi John

    I am afraid I am going to have to ask about question one. As per your lecture notes “The general rule is that we are interested in all future, incremental (or extra), cash flows to
    the company as a result of undertaking the investment”. And in the online lecture for example one you stripped out the cost of labour from the prime costs as it has to be paid regardless.

    Could you possibly explain to me how question one here is different to example one in the lecture notes? As far as I can see they both are not extra cash flows and are therefore irrevelant.

    Thank you
    William

    • It is the same as in example 1in the lecture notes – the labour is being paid anyway and so is not a relevant cost.

      In example 1, the contribution is 150,000 – 100,000 = 50,000.
      The cost of using the labour is the contribution plus the cost of the labour, which is 50,000 + 40,000 = 90,000.

      (Alternatively, if you prefer, then in test question 1. The contribution is $12 per hour but this is after charging labour of $10 an hour, which is payable anyway. Therefore the cost will be the net of the lost revenue and all other variable costs, which is 10 + 12 = $22 per hour)

      I do assume that you are not just using the notes on their own, but that you are watching the lectures that go with them. In the lectures I explain and expand on the notes – the notes on their own are not enough. If you are not watching the lectures then you must buy a Study Text from one of the ACCA approved publishers and study from there.

      • Hi John

        Yes I am using the lecture notes and the online lectures. I just rewatched the lecture. (With the lecture notes) and arrived at the same place as before. As per the lecture-

        Labour
        Lost revenue – 150,000
        Save materials (60,000)
        = relevant cash flow of 90,000.

        And quoting your lecture “these workers being paid, we will pay the Labour whatever happens. If they work on this project, this new project, we will pay them 40,000. If we stop the project and instead they may the other product, we will pay them 40,000. So there is no extra costs or savings involved there.we are paying the Labour anyway”

        The two are contradictory in my eyes

      • Also even in your reply you are not counting labour

        Sales – prime cost + labour= sales – materials- Labour+ labour = sales- materials

      • There is nothing contradictory at all.

        Suppose labour is currently being used on a product that sells for 100, has labour costs of 20 and other variable costs (materials etc) of 30. So the contribution is 100 – 20 – 30 = 50.

        Suppose the labour is taken for another contract. We lose the revenue of 100, we save the other variable costs of 30, but the labour is still being paid. So the net loss – the relevant cost – is 100 – 30 = 70.
        This is always the same as the contribution plus the labour i.e. 50 + 20 = 70.

      • Finally it clicks. Contribution was what is making me wrong. Finally I realise that Labour has to be added back into the contribution to get the sales.

        Thank you!!

  14. Hi,

    This is my first post and I really appreciate the effort by tutor John, I have study material from Kaplan but need more clarity on various concepts and explored this site.

    My inquiry is on question which has earning $5000 in perpetuity, the answer is bit confusing, here are reasons: first if we use formula for perpetuity with growth which is 1/r-g the answer should be $62500. If we follow approach given in above answer then how we know that given cost of capital is in money term and we need to find real term then it will make sense to use fisher formula 2nd point is even if we assume given is the money cost of capital and by using fisher formula we found real cost of capital but by applying 5,000 x 1/0.769231 is not giving 65000. I will appreciate if you can explain.

    • Two things.

      Firstly the cost of capital is always the nominal/actual cost of capital unless you are specifically told otherwise.

      Secondly, the real cost of capital is 7.69231% which is the same as 0.0769231 (not 0.769231 as you have typed – that would be 76% 🙂 )

  15. hi sir,with regard to question 1,why are we taking labor cost $10 as relevant.we are already paying the labours.the only relevant cost which seems obvious to me is the lost contribution.
    can u kindly correct me if i m wrong.

      • Both of you really should watch my free lectures, because I do explain in the lectures (and also it is a popular question in the exam).

        Suppose men are currently working on another product which has a selling price of 100, labour cost of 20, and other variable costs (materials etc) of 10. So a contribution of 70.
        If the man are taken off this work, we lose the revenue of 100 and we save the other variable costs of 10. (The labour is still being paid). So the net cost is 100 – 10 = 90 (which is always the same as the lost contribution plus the labour cost: 70 + 20 = 90)

  17. Hi John,
    In question 1, the workers are paid $10 per hour….this would remain the same if they are shifted to work on the new project. why then is this $10 relevant? Shouldn’t the relevant cost just be the opportunity cost of $12 x 500 = $6000 ?

    • No – if they are taken from other work then the cost is always the labour cost plus the lost contribution.

      To explain, just suppose the other work gives revenue of 50, labour cost is 10, and materials are 28. So contribution is 12.
      If labour is taken to use elsewhere then we lose the revenue of 50 but we no longer need to pay for materials of 28. (Labour is still paid for). So the net loss is 50 – 28 = 22, which is the same as contribution plus labour.

      • Hi, so mean that if these workers are not taken from current work, this labor cost is not relevant. That’s what you mean? The point is TAKEN OFF FROM CURRENT WORK?

  18. Hi John,

    I am struggling to understand question number two-relevant cost.
    I understand that we will lose $12.00 contribution, therefore that is a relevant cost but I am not sure why we include the $10 for wages, surely that is a cost we would have to pay to our staff regardless of taking on this new project.
    Many thanks

    • We would still be paying the wages, but we would lose the revenue but save on the other variable costs. The revenue less the other variable costs is equal to the contribution plus the labour.
      For a full explanation and examples you need to watch the free lectures on relevant costing.
      (Our free lectures are a complete course for Paper F5 and cover everything needed to be able to pass the exam well).

  19. Hi John,

    Going to back the same question that MahdiB7 asked – Question 2.

    Does that mean if a project is to earn $ for perpetuity, you will always use real cash flow regardless of any inflation or tax implications.

    Many thanks for your help.
    Monika

    • It is not possible to use the nominal flows – you have no choice by the use the real cash flows.
      That is accounting for inflation – the nominal and real cash flows would be the same if there was no inflation.

      Tax will be discounted in the same way – using real cash flows is not ignoring tax at all.

      • Sorry but please give more details about which question you mean.
        The reason is that they questions appear in a random order and so question 4 might be question 1 for somebody else and so I don’t know which one you mean 🙁

        (It has now been fixed and the questions do all appear in the same order, so in future it will not be a problem)

      • Thanks for your reply John

        The question is as follow:

        A project is expected to earn $5000/ year (at current prices) is perpetuity, inflating at 4% per year. the first receipt will be in one year time. the cost of capital is 12%.

        what is the PV of the receipts? $65000/$41700/$62500/$58000.

        The correct answer is $65k but i don’t get how you get to this?

        Thanks in advance. I much appreciate your help.

      • Because the flow is in perpetuity, you have to discount the real flows (i.e. the current price flows ignoring inflation) at the real (or effective) cost of capital which is calculated using the Fisher formula on the formula sheet. (This is dealt with in our Lecture Notes and the lectures that go with them)

        The real cost of capital = 1.12/1.04 -1 = 0.0769231 (or 7.69231%)

        Discounting the current price flow in the normal way for a perpetuity gives 5,000 x 1/0.769231 = 65,000.

        Alternatively, you can use the dividend valuation formula given on the formula sheet (it works for any inflating perpetuity – not only dividends).
        So PV = (5,000 x 1.04) / (0.12 – 0.04) = 65,000

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