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?

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).

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

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.

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

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?

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?

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.

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.

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.

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.

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.

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.

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.

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.

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.

amaa2000 says

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?

John Moffat says

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).

Veromitch says

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

John Moffat says

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).

Veromitch says

Thanks a lot, sir

jackdunn1294@gmail.com says

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.

Veromitch says

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

ASHEETA says

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?

John Moffat says

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).

Shaurya@123 says

Sir as the capital allowances is getting nullified. So, if we do not take that into our calculation it will be correct or not

John Moffat says

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.

piumiwijayasena says

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?

John Moffat says

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.

mzeeobey says

Doesnt it result in a benefit an inflow

mzeeobey says

Just the same way capital allowances do

gouthamjp94 says

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.

jaumbocus says

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.

John Moffat says

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.

ABDULLAHI312 says

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.

John Moffat says

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.

umarmohammed says

Fast forward to the 19th minute and listen to him carefully

Sharmaarke says

Waryaa bal waran.

Palmcy says

Hi John,

Could you explain why tax savings on the WDAs were not included in the computation?

John Moffat says

They are included!!! The tax has been calculated on the profit less the capital allowances.

haider10793 says

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.

John Moffat says

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.

Kyle says

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

John Moffat says

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.