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Hello sir,
Could you please explain that why TAD is not added back after tax applied. It has been added neither in official answers nor in other tutor lessons.
Thanks in advance
In Paper FM, we subtract the TAD when calculating the cash flows, then calculate the tax, and then add back the TAD because it is not a cash flow.
The reason that in Paper AFM this approach does not always work is that there can be tax losses in which case the tax for that year is zero and the loss is carried forward to reduce the taxable profits of future years.
For that reason it is safer in Paper AFM to calculate the tax in separate workings, as I do make clear in my free lectures. If there are separate tax workings (as in the question you refer to) then since the TAD is not subtracted when calculating the cash flows, there is nothing to add back. I have no idea which ‘other tutor lessons’ you are referring to, but I am very surprised if they do not explain the above 🙂
Please for clarifications related to 2 narrative parts of Zhichi Co question.
1. In requirement (a) answer, it is written:
“Information asymmetry between investors and a company’s managers sends signals that the company is only raising equity finance when share prices have peaked or shares are over-valued. This causes share prices to fall following announcements that a company is raising new equity financing.”Please, explain and clarify this asymmetry and the next sentence for the fall in share prices?
2. APV vs NPV- requirement b (iv) answer, it is written:
“APV does not normally take into account costs of financial distress, possibility of tax exhaustion and agency costs related to financing using debt. However, in Zhichi Co’s case, none of these is likely to be an issue because it has only used equity financing previously and therefore the impact of the above is likely to be minimum.”Please, explain and clarify these two sentences, and especially some words separately for this financial distress, tax exhaustion and agency costs?
Just, for example, agency costs are key part in each APV calculations approach. Why APV does not normally take them into account 🙂 ?
1. This needs to be read in the context of the whole paragraph for that part of the answer. The point you need to be making is that the company appear to prefer raising equity rathe than debt, whereas the investors (via the analysts) feel that it would be better to finance projects by riding more debt.
2. Because APV is essentially using Modigliani and Millers hypothesis regarding the tax benefits attributable to debt, they are subject to the M&M assumptions which (as I explain in my free lectures) assume that there will be a full tax benefit from raising debt (which might not be the Sade if the profits are not high enough – that is tax exhaustion) and that they ignore financial distress (that is the risk of the company going bankrupt – MM only consider the risk due to debt arising from the higher fixed interest payments). Agency costs are not the costs of raising the debt – they refer to the managers making different decisions than are best for the shareholders, and again MM ignore this.
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