Apologies for another question, but should we use $000's in the exam even though we will be using spreadheets?
L
loukasierides·
Yes, it should come to the same answer, I realized by attempting the Sleepon Hotels question
J
John MoffatTutor·
It doesn’t matter (unless the question specifies what to use).
L
loukasierides·
Hello Sir,
How come for year 1 revenue is $2.000 but for Materials $864, shouldn't materials inflate at year 2? Shouldn't materials be $800 in year 1?
L
loukasierides·
That's fine Sir, I am guessing the question states selling price will increase after the first year, while inflation on costs takes place from time zero up to the end of year 1.
A
Ahmed·
Hello Sir. Thank you for the great lecture, it was highly informative. I have two questions.
First, same as one of the fellow OT members asked above, why is depreciation not included in example 1 calculation? Is it because Capital allowances reflects depreciation, but with adjustments for tax?
Second, why is that once I used the NPV formula on excel my answer was 234,768?
For the NPV formula I entered the following arguments: = (NPV, 10%, Net Cashflows from years 0:5 (before discounting)). However, when I did it manually, like you did, I got the same answer as you NPV = 258,244?
J
John MoffatTutor·
Depreciation is never relevant because it is not a cash flow and DCF appraisal only considers cash flows.
Capital allowances are only relevant insofar as they affect the tax charge.
I can't explain your second question without seeing the cash flows. There will always be some difference due to the tables being rounded to 3 decimal places (and any difference due to this is irrelevant in the exam).
V
Vero·
Please sir, if we are given after-tax cost of capital and nominal after-tax cost of capital, which one should be used for the discounted cashflow calculation?
Thank you
J
John MoffatTutor·
We use the nominal (i.e. actual) cost of capital on the actual cash flows (after inflating them).
We use the real cost of capital (i.e. after removing the inflation) on the real cash flows (i.e. ignoring inflation). However this is rarely relevant for Paper AFM.
You can find a full explanation of what to do and when in my free Paper FM lectures on investment appraisal with inflation. (Paper AFM questions on this are revision from Paper FM).
Very well taught. Whilst I understand the logic of not absorbing the overheads into the project appraisal, in practice I would argue this is something that should be done. In the business I work for we would do this to ensure the group overhead is always supported by its subsidiary operations.
V
Vero·
Please sir, if we are given after-tax cost of capital and nominal after-tax cost of capital, which one should be used for the discounted cashflow calculation?
Thank you
A
ASHEETA·
Hello Sir.
If in any question, it is mentioned that the production and sales are expected to increase by 2.5% per annum, then are we supposed to make this adjustment as from year 1 or year 2?
J
John MoffatTutor·
It depends on the rest of the wording (whether you are told the amounts at current levels are at the levels in the first year).
S
Shaurya·
Sir as the capital allowances is getting nullified. So, if we do not take that into our calculation it will be correct or not
J
John MoffatTutor·
They are not getting 'nullified' and it certainly will not be correct if you leave them out of the calculation!!
It may help you to watch our Paper FM lectures on 'investment appraisal with taxation', because this is revision from Paper FM.
P
piumiwijayasena·
Hi John,
why aren you deduct fixed Overhead cost to calculate taxable profit. i understand we dontt deduct fixed overhead to calculate net cash flow. but to arrive at taxable profit, we can include fixed overhead?
J
John MoffatTutor·
It is only any extra fixed overheads that affect the extra cash flow, and only any extra fixed overheads that will affect the profit and therefore the tax.
O
Oby·
Doesnt it result in a benefit an inflow
O
Oby·
Just the same way capital allowances do
G
Goutham·
Hi Mr John,
First of all thanks for such amazing lectures.
I had a doubt in the depreciation calculation.
In the question we had the machinery for 5 years right?
So should the year 5 depreciation of 142 (calculated at 25% of 570 ) also be deducted from the WDV before adding the scrap value?
Thanks in advance.
J
jaumbocus·
Hi Thank you for the great lecture. I have one question: have we used this bit of information:
Fixed overheads of the company currently amount to $1,000,000. The management accountant has
decided that 20% of these should be absorbed into the new product.
Thank you in advance for the clarification.
J
John MoffatTutor·
Fixed overheads are only relevant if the total amount paid by the company changes because of doing the new project. Simply absorbing (charging) the overheads in a different way between projects for accounting does not mean that the total being paid is changing, and so is not relevant.
A
ABDULLAHI·
sir, it was confusing to subtract the tax on capital allowances and then add them back again. i think in paper FM it was a bit straight as we calculated the tax savings on the capital allowances and tax on net operating flow. i tried and it is giving the same answer as your computation here. i find the FM way easier and time saving. thanks john.
J
John MoffatTutor·
Either way is fine in this question. Where there can be a problem is if the investment is in another country (as is often the case in AFM). If there is a loss then there will be no tax in the year of the loss, but the loss will be carried forward to reduce the taxable profits in later years.
U
umarmohammed·
Fast forward to the 19th minute and listen to him carefully
N
Noman·
Waryaa bal waran.
P
Palmcy·
Hi John,
Could you explain why tax savings on the WDAs were not included in the computation?
J
John MoffatTutor·
They are included!!! The tax has been calculated on the profit less the capital allowances.
H
Haider·
Hi John. For material expenses in the first example, why do we take the amount post-inflation? As we will start spending on materials and labour immediately and therefore should consider the current prices.
J
John MoffatTutor·
Although in practice prices are likely to increase little by little throughout the year, in exam questions we always assume that the current price is the price this year (before the investment has been made) and that the price next year (when the project has been started) will be higher by the rate of inflation.
K
Kyle·
Hi John,
If tax is payable immediately, could you briefly explain why no capital allowances are claimed in the year the machinery is purchased to generate an operating loss? I somewhat get it, but a definitive answer/rule would be welcomed.
Many thanks,
Kyle
J
John MoffatTutor·
I assume that you are referring to example 1, in which case there are capital allowances in the first year of 25% x 1,800 = 450, which result in a tax saving of 450 x 25% = 113 at time 1.
Just as in Paper FM, we assume that the company is already making profits and is therefore already paying tax. If the project generates a taxable profit then there is extra tax payable, whereas if the project results in a taxable loss then the company as a whole makes less profit which results in a tax saving due to the project.
We always assume this except in two circumstances. One is obviously if the question specifically states otherwise. The other, more importantly, is if the project is in a different country. In that case tax is payable in the other country and if there is a tax loss then the loss is carried forward against future taxable profits. I do explain this in one of the later lectures in this series.
D
Dany·
Hi Sir,
Why has the revenue for year 1 not been adjusted for the growth of 7%?
Could you please clarify.
J
John MoffatTutor·
Because the question specifically says that the selling price will be $20 in the first year.
D
dosan·
HI John Moffat
WHAT ADJUSTMENT DO WE DO IF WE ARE TOLD THAT " it can be assumd that the amount of taxallowable depreciation is the same as the investment needed to maintain Company operations"
J
John MoffatTutor·
I explain this in the lecture working through example 4 in the chapter!
D
David·
Good day sir, I just want to confirm with regard to the method explained in the video,
It seems like the method is not different from free cash flow model to the firm and if they are different, may you sir please help differentiate the two for me.
J
John MoffatTutor·
It is the only method (just as in Paper FM) and is the same for the same reasons :-)
G
GHULAM·
Hi Sir, I didn't understand the Tax on saving on capital allowed. How these figures are calculated 113, 84, 63, 47, and 107. I believe the method is not the same as in the video lecture. Can you please explain it to me.
Secondly, in the notes' answer, the tax is directly calculated on operating profit while in the video lecture you are calculating after deducting the Capital allowance.
J
John MoffatTutor·
Just as in Paper FM (was F9) you can do it either way (and get the same answer).
Either subtract the capital allowances, then calculate the tax, then add back the capital allowances, or alternatively calculate the tax on the profit before allowances and then calculate the tax saved due to the allowances. (The allowance in the first year is 450 and therefore the tax saved is 450 x 35% = 113. Same for the later years.)
If you are still unsure then watch the Paper FM lectures on investment appraisal with tax for revision.
G
GHULAM·
Your answer is helpful, thank you so much,
J
John MoffatTutor·
You are welcome :-)
N
Noah·
sir why are scrap proceeds not taxable gain?
J
John MoffatTutor·
Capital gains tax is not examinable in Papers FM and AFM.
N
Noah·
Oh yesss!! am so sorry sir for asking such a silly question
H
Husnain·
Hello John,
kindly explain me as i did not understand the fact why Capital allowances were deducted first and then again added back i-e what is the logic behind it,
Are'nt capital allowances are relevent cashflows if they are not then why do we subtract and add them ?
J
John MoffatTutor·
Capital allowances (tax allowable depreciation) are not cash flows (just as accounting depreciation is not a cash flow).
We subtract it in order to get the taxable profit on which the tax is calculated.
Having calculated the tax we then add it back because it is not a cash flow.
I suggest that you watch the Paper FM lectures on investment appraisal with tax, because this is revision from Paper FM (was Paper F9).
A
ashking21·
Hi John,
Thank you for the lecture. Please guide me on why did you not take the depreciation in year 5?
Thank you in advance.
J
John MoffatTutor·
Because in the final year there is a balancing charge or balancing allowance. If you have forgotten the way we deal with tax then do look back at the 'investment appraisal with tax' lectures for Paper FM (was F9).
R
Ritika·
Hello Sir,
Thanks for the amazing lectures?
I have a doubt regarding NPV calculation. If we are financing a project through equity issue and incur issue cost on the equity market issued.
Do we include the equity issue cost as a cash outflow in NPV calculation ?
J
John MoffatTutor·
Yes, but this is only likely ever to be relevant in an APV question.
R
Ritika·
That means we would not treat issue cost as sunk or committed cost ?
A
Adam·
Hi,
Please can you explain why you do not use the method shown in FM by calculating and deducting tax on the operating cash flows then dealing with the capital allowances after.
Thanks
J
John MoffatTutor·
In Paper FM the investment is always in the same country as the company, and we always assume the company is already making profits and paying tax. Therefore they always get the benefit of the tax saving on CA's even if the operating profit from the investment is less than the CA's.
In AFM the investment is often in another country in which case the tax is in the other country and if the investment makes a tax loss (because the CA's are greater than the operating profit) then there is no tax payable for that year and the loss is carried forward to reduce the taxable profit in later years.
If there are no tax losses then either approach will give the same answer, but because there are quite likely to be tax losses in an AFM question with an investment in another country, it is safer to take this approach.
G
Gnoii·
Dear sir,
There should be no taxation in year making loss, if any carried forward amount which should be included in next year of profit. So I got confused with the taxation in year 1, should we deduct into taxation in year 2 instead?
Thank you very much for the lecture.
J
John MoffatTutor·
Just as in Paper FM (was Paper F9) we always assume that the company is already making profits and is already paying tax. Therefore a 'loss' from a new project simply reduces the company overall profit and therefore reduces the overall tax payable - therefore there is a tax saving to be made (and no loss relief).
(It may help you to watch the Paper FM lectures on investment appraisal with tax)
The exception to this is where there is an investment in a foreign country. In that case if. the project does have a loss, then the loss is carried forward and reduces the taxable profit in the following year. I show this in a later example.
M
Mykola·
Hi!
I have a question on capital allowances.
Could you please explain why do we calculate capital allowances taking 1,800 as a basis?
Shouldn't we calculate Depreciable Cost (as the Actual cost minus Scrap value) and work with it further?
I mean, why don't we calculate basis for depreciation as:
1,800 - 1,000 = 800, and calculate dpn further with reducing balance approach:
Dpn in Year 1: 800 * 25% = (200)
Dpn in Year 2: (800-200)*25% = (150)
Dpn in Year 3: (600-150)*25% = (112.5)
Dpn in Year 4: (450-112.5)*25% = (84.38)
Dpn in Year 5: Balancing figure = (253.12)
Total Dpn for 5 years: (800)
A little bit confused..
Many thanks for video lectures!
Nick
J
John MoffatTutor·
I don't know whether or not you have taken the tax paper, but capital allowances are always calculated on the initial cost. Any scrap proceeds are dealt with at the end and result in a balancing charge or allowance.
We are not calculating accounting depreciation, we are using tax rules (and the tax people do it the way I do in the lecture (and the way we do in exams)) because the tax people have no idea what scrap value there will be (if any) until it is actually scrapped.
M
Mykola·
Got it.
Thank you!
J
John MoffatTutor·
You are welcome :-)
U
usama93·
Hi John,
Thank you for the lecture. Please guide me on why did you not take the depreciation in year 5?
Thank you in advance.
E
elizabeth2018·
Excellent lecture John! Still unclear on the materials and labour being inflated in year one, but the rest of it was brilliant. I hope you are keeping well.
Your website is my first point of call each time there is an exam - albeit I have had to put proceedings on hold for the past year - so, in the nicest way possible, I hope to soon no longer require your help (on the count of this being one of the two remaining) :)
J
John MoffatTutor·
Thank you for your comment - do ask in the Ask the Tutor Forum if you do have any problems.
If you are told that flows are in current prices, then automatically they inflate in the first year.
J
John MoffatTutor·
rorymcmonagle: It is of no relevance whether or not the project is 'using them'. A fundamental concept involved in DCF investment appraisal is that we are only interested in the future incremental cash flows to the company as a result of doing the project. The total fixed overheads for the company will remain the same whether or not the project is undertaken. They are therefore of no relevance when deciding whether or not the project is worthwhile.
R
rorymcmonagle·
Hi
I dont understand why overheads of 20% of 1,000,000 are not included. If we are deciding they are absorbed by the project, we are deeming that the project uses them? Or is it that they would happy anyway without the project?
Thanks
J
John MoffatTutor·
Sheshe1310: Thank you for your comment :-)
S
sheshe1310·
I'm so amazed by the simplicity of the lecture.Learning is so easy listening to the lectures.I am very grateful to you sir.
W
Wasim·
Thank you for the excellent lecture, just one question though. Do we just assume our working capital requirements face no inflation? How different would the treatment be if that were not the case?
J
John MoffatTutor·
If the working capital inflated then extra working capital would be need each year (by the amount of the inflation).
T
tryphine·
Thanks for a good lecture sir.
J
John MoffatTutor·
Thank you very much for your comment :-)
A
asher100·
1-Shouldn't the inflationary effects on materials and labour come into effect after the first year, i.e. reflected only in columns 2-5 for materials and labour?
2-Why would working capital be returned at the end of the project? Wouldn't it be likely put to use and used up over the course of the five years?
J
John MoffatTutor·
No to both, and I explain the reason for both in the lecture!!
1, Materials and labour are given in current prices - i.e. the price quoted before we have even decided whether or not to go ahead with the project. If we do go ahead, then the price in the first year of the project will be higher by the rate of inflation.
2. What do you mean by 'put to use'?? Working capital is things like the fact they need to buy inventory of materials at the start of the project in order to facilitate production. Once production stops, the no longer need to carry the inventory.
How come for year 1 revenue is $2.000 but for Materials $864, shouldn't materials inflate at year 2? Shouldn't materials be $800 in year 1?
First, same as one of the fellow OT members asked above, why is depreciation not included in example 1 calculation? Is it because Capital allowances reflects depreciation, but with adjustments for tax?
Second, why is that once I used the NPV formula on excel my answer was 234,768?
For the NPV formula I entered the following arguments: = (NPV, 10%, Net Cashflows from years 0:5 (before discounting)). However, when I did it manually, like you did, I got the same answer as you NPV = 258,244?
Capital allowances are only relevant insofar as they affect the tax charge.
I can't explain your second question without seeing the cash flows. There will always be some difference due to the tables being rounded to 3 decimal places (and any difference due to this is irrelevant in the exam).
Thank you
We use the real cost of capital (i.e. after removing the inflation) on the real cash flows (i.e. ignoring inflation). However this is rarely relevant for Paper AFM.
You can find a full explanation of what to do and when in my free Paper FM lectures on investment appraisal with inflation. (Paper AFM questions on this are revision from Paper FM).
Thank you
If in any question, it is mentioned that the production and sales are expected to increase by 2.5% per annum, then are we supposed to make this adjustment as from year 1 or year 2?
It may help you to watch our Paper FM lectures on 'investment appraisal with taxation', because this is revision from Paper FM.
why aren you deduct fixed Overhead cost to calculate taxable profit. i understand we dontt deduct fixed overhead to calculate net cash flow. but to arrive at taxable profit, we can include fixed overhead?
First of all thanks for such amazing lectures.
I had a doubt in the depreciation calculation.
In the question we had the machinery for 5 years right?
So should the year 5 depreciation of 142 (calculated at 25% of 570 ) also be deducted from the WDV before adding the scrap value?
Thanks in advance.
Fixed overheads of the company currently amount to $1,000,000. The management accountant has
decided that 20% of these should be absorbed into the new product.
Thank you in advance for the clarification.
Could you explain why tax savings on the WDAs were not included in the computation?
If tax is payable immediately, could you briefly explain why no capital allowances are claimed in the year the machinery is purchased to generate an operating loss? I somewhat get it, but a definitive answer/rule would be welcomed.
Many thanks,
Kyle
Just as in Paper FM, we assume that the company is already making profits and is therefore already paying tax. If the project generates a taxable profit then there is extra tax payable, whereas if the project results in a taxable loss then the company as a whole makes less profit which results in a tax saving due to the project.
We always assume this except in two circumstances. One is obviously if the question specifically states otherwise. The other, more importantly, is if the project is in a different country. In that case tax is payable in the other country and if there is a tax loss then the loss is carried forward against future taxable profits. I do explain this in one of the later lectures in this series.
Why has the revenue for year 1 not been adjusted for the growth of 7%?
Could you please clarify.
WHAT ADJUSTMENT DO WE DO IF WE ARE TOLD THAT " it can be assumd that the amount of taxallowable depreciation is the same as the investment needed to maintain Company operations"
It seems like the method is not different from free cash flow model to the firm and if they are different, may you sir please help differentiate the two for me.
Secondly, in the notes' answer, the tax is directly calculated on operating profit while in the video lecture you are calculating after deducting the Capital allowance.
Either subtract the capital allowances, then calculate the tax, then add back the capital allowances, or alternatively calculate the tax on the profit before allowances and then calculate the tax saved due to the allowances. (The allowance in the first year is 450 and therefore the tax saved is 450 x 35% = 113. Same for the later years.)
If you are still unsure then watch the Paper FM lectures on investment appraisal with tax for revision.
kindly explain me as i did not understand the fact why Capital allowances were deducted first and then again added back i-e what is the logic behind it,
Are'nt capital allowances are relevent cashflows if they are not then why do we subtract and add them ?
We subtract it in order to get the taxable profit on which the tax is calculated.
Having calculated the tax we then add it back because it is not a cash flow.
I suggest that you watch the Paper FM lectures on investment appraisal with tax, because this is revision from Paper FM (was Paper F9).
Thank you for the lecture. Please guide me on why did you not take the depreciation in year 5?
Thank you in advance.
Thanks for the amazing lectures?
I have a doubt regarding NPV calculation. If we are financing a project through equity issue and incur issue cost on the equity market issued.
Do we include the equity issue cost as a cash outflow in NPV calculation ?
Please can you explain why you do not use the method shown in FM by calculating and deducting tax on the operating cash flows then dealing with the capital allowances after.
Thanks
In AFM the investment is often in another country in which case the tax is in the other country and if the investment makes a tax loss (because the CA's are greater than the operating profit) then there is no tax payable for that year and the loss is carried forward to reduce the taxable profit in later years.
If there are no tax losses then either approach will give the same answer, but because there are quite likely to be tax losses in an AFM question with an investment in another country, it is safer to take this approach.
There should be no taxation in year making loss, if any carried forward amount which should be included in next year of profit. So I got confused with the taxation in year 1, should we deduct into taxation in year 2 instead?
Thank you very much for the lecture.
(It may help you to watch the Paper FM lectures on investment appraisal with tax)
The exception to this is where there is an investment in a foreign country. In that case if. the project does have a loss, then the loss is carried forward and reduces the taxable profit in the following year. I show this in a later example.
I have a question on capital allowances.
Could you please explain why do we calculate capital allowances taking 1,800 as a basis?
Shouldn't we calculate Depreciable Cost (as the Actual cost minus Scrap value) and work with it further?
I mean, why don't we calculate basis for depreciation as:
1,800 - 1,000 = 800, and calculate dpn further with reducing balance approach:
Dpn in Year 1: 800 * 25% = (200)
Dpn in Year 2: (800-200)*25% = (150)
Dpn in Year 3: (600-150)*25% = (112.5)
Dpn in Year 4: (450-112.5)*25% = (84.38)
Dpn in Year 5: Balancing figure = (253.12)
Total Dpn for 5 years: (800)
A little bit confused..
Many thanks for video lectures!
Nick
We are not calculating accounting depreciation, we are using tax rules (and the tax people do it the way I do in the lecture (and the way we do in exams)) because the tax people have no idea what scrap value there will be (if any) until it is actually scrapped.
Thank you!
Thank you for the lecture. Please guide me on why did you not take the depreciation in year 5?
Thank you in advance.
Your website is my first point of call each time there is an exam - albeit I have had to put proceedings on hold for the past year - so, in the nicest way possible, I hope to soon no longer require your help (on the count of this being one of the two remaining) :)
If you are told that flows are in current prices, then automatically they inflate in the first year.
I dont understand why overheads of 20% of 1,000,000 are not included. If we are deciding they are absorbed by the project, we are deeming that the project uses them? Or is it that they would happy anyway without the project?
Thanks
2-Why would working capital be returned at the end of the project? Wouldn't it be likely put to use and used up over the course of the five years?
1, Materials and labour are given in current prices - i.e. the price quoted before we have even decided whether or not to go ahead with the project. If we do go ahead, then the price in the first year of the project will be higher by the rate of inflation.
2. What do you mean by 'put to use'?? Working capital is things like the fact they need to buy inventory of materials at the start of the project in order to facilitate production. Once production stops, the no longer need to carry the inventory.