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Discounted cash flow techniques (part 3) – ACCA (AFM) lectures

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  1. Hi John, thanks heaps for the excellent lecture.
    As you mentioned in the previous lecture, investment in a foreign country is different from buying a machine, losses can be carried forward for next year’s tax calculation purpose.
    Based on above, I have 2 questions regarding example 4
    1. why the initial investment of (4545) GBP at time 0’s can not be carried forward?
    2. if at time 1, we have a loss, can it be carried forward for time 2’s tax calculation?

    Thank you very much in advance!

  2. Hi,

    I only have one technical question regarding the Notes to the course. I can’t find in the Answers section the solutions for Example 4, 5 and 6 under this chapter. I was actually doing a recap and wanted to check against the workings there and that’s when i noticed.

    Many thanks,
    Laura

  3. Hi John,

    Thank you for the lecture! Just a question here – why there is a need to add back the depreciation in this case while you did not add back the depreciation in the last example in part 1?

    Thanks!!

    • In example 1 we add back the depreciation because it is not a cash flow – the way we normally do it for Paper FM (was F9). It is subtracted in order to calculate the tax but is then added back because it is not a cash flow.

      In example 4, we do not add it back because although it is not a cash flow, the question specifically says that an amount equal to the depreciation is needed for the maintenance of the assets.
      As I say in the lecture, this is what the current examiner almost always writes as part of the question.

  4. Hello John,

    I am a bit confused regarding depreciation.in the previous eg the depreciation was taken for 4 years wherese in this eg it has been taken for 5 years.

    I have already posted a query in ask my tutor forus which i suppose u havent come across.

    thanks

    I love your way to tutoring

    • I did answer your post in the Ask the Tutor Forum earlier today.

      The same rule has been applied in both examples. In Example 1 there is a scrap value at the end of 5 year, and the TAD in the 5th year is the difference between the sale proceeds and the tax written down value.

      In Example 4, there is no scrap value (so the sale proceeds are zero) and therefore the TAD is the difference between the tax written down value and zero.

  5. Dear John,

    It is stated that the amount equal to the amount of the tax allowable depreciation is required each year for the maintenance of non-current assets.

    As I understand this amount is the cash item which Oblivia project has to spent on the FA maintenance. Means, this is the real expenses, which were spent by the company and could be deducted in the tax calculation in addition to TAD.

    My Question is: Why during the tax calculation we didn’t deduct 20% twice? on tme as TAD, and second time as expenses spent for maintainance

    Thanks,
    Pave

      • Technically, the maintenance should be deducted to get a lower taxable profit which will lead to reduced tax. After which the CA can be deducted to get the “new taxable profit” and the respective tax and then add back the CA which will give the same results but still the reduced tax from the maintenance is not accounted for. How should we do this if we encounter this in the exam because I am sure it is wrong.

    • The initial cost is $5,000,000 and the question says that TAD is 20% straight line, which is therefore $1,000,000 per year.

      What you are confusing is that the tax saved as a result of the TAD will be the tax rate (which is 25% and not 20% in the question) as applied to the $1,000,000.

      This is happening here – the tax has been calculated on the profit after the TAD.

  7. Hello John,

    I will really appreciate if you can help provide some clarification on how to calculate the average inflation rate for the data below.

    Expected inflation rates
    EU expected inflation rate: Next two years 5%
    EU expected inflation rate: Year 3 onwards 4%
    USA expected inflation rate: Year 1 onwards 3%

    The actual question says “The current selling price of each component is €700 and this price is likely to increase by the average EU rate of inflation from year 1 onwards”.

    Thanks.

    • In future please ask this kind of question in the Ask the Tutor Forum, and not as a comment on a lecture.

      The inflation rates are given in the question – calculating any sort of average rate is of no relevance at all.

      If the current price is €700, then the price in 1 year will be 700 x 1.05.
      The price is 2 years will be 700 x 1.05^2
      The price in 3 years will be 700 x 1.05^2 x 1.03
      From then on you multiply by 1.03 each year.

      It may help you to watch the Paper FM (was F9) lectures on investment appraisal with inflation.

  9. Dear Sir,

    If the question says “Assume there is no tax relief ” , i believe we tax at their respective rates and not the difference. However, when taxing at the home country, do we tax on taxable profits or the Operating profit ( before capital allowance) ?

    A question in the BPP textbook shows that we tax at Operating Profit and not taxable profits. Why so?

  10. Dear Sir,

    Please explain the following

    A) The concept of Tax saving on Tax allowable depreciation as it was not discussed while solving Example 4

    B) The Concept of Double tax treaty: What would have happened if there was no double tax treaty between Uk and Oblivia, We would have then taxed the cashflows as per the respective tax rates in both countries

    C) Royalties: Why were they added separately to James plc cashflows when the Cashflows received from Oblivia were already net of the royalty payment to James plc and Why were they taxed at 25 % and not the incremental of 5%

    • A. You should remember from Paper PM ((was F9) that TAD can be dealt with in 2 ways – both giving the same result. In Paper PM is more common to calculate the tax on the cash flows ignoring TAD and then bring in the tax saving on the TAD.
      The other way was to calculate the tax after subtracting the TAD, and then add back the TAD because it is not a cash flow. In AFM it is better to use the second way (as I have done in example 4). However the TAD is not added back, because although it is not a cash flow, the question says that an equal amount is needed for the maintenance of non-current assets. I explain about this in the lectures, and as I say in the lecture it is something the current examiner does in all NPV questions.

      B. Yes – both sets of flows would have been taxed at the relevant rates. However in every singe exam question a double tax treaty has existed.

      C. The royalties are an expense of the company in Oblivia and therefore reduce the Oblivia profits. They are income to James in the UK and are therefore taxed in the UK. This is standard tax rules as well as always being the caae in AFM questions.

      • Dear Sir,

        Will the examiner always mention that an equal amount Is needed to maintain the non current asset If not can we assume and do our workings according to that?

      • These days, the examiner always assumes it in his answers (whether or not it is mentioned in the questions). As always, in AFM, state your assumptions and if they are valid then you will still get the marks even if different from the examiners answer.

      • Dear John,

        In Q1 June 2015 named Yilandwe Co, the examiner has first deducted the TAD and then added it back later, The question does not state any thing about the same amount being used to maintain the non current asset. How should we deal such questions?

  13. Hi John

    In example 4, James Pls question we deducted € 1000 depreciation to arrive taxable profit. It’s clear. But shouldn’t we deduct another € 1000 as a maintenance cost to arrive taxable profit ? Question says an amount equivalent to depreciation is required each year to maintain non current assets, so it means in addition to depreciation (non cas expenses) there will be another € 1000 cas out each year for maintenance of non current assets.

    Bit concern about the clear treatment as this will be checked in next exam as well

    Thanks

    • You have a valid point, but the examiner always ignores this possibility – he always subtracts the depreciation, treats the remainder as being the taxable profit, but then does not add back the depreciation because the same amount is spent on maintaining the assets.

      • Hi John

        Still its not clear on what basis maintanance cost is excluded from the taxable profit calculation. If i include both maintainance and capital allowances for taxable profit calculation in my working will that be incorrect?

      • As I wrote before, what you are saying is sensible. However it would make sense to do what the examiner always does, to be sure of getting the marks.

  14. Hi John
    why is depreciation is not added back after it is used for tax calculation purposes for the purpose of NPV calculation this is not cash item? As far as I know depreciation is to be used only to reduce taxable base… so following that logic they should be added back.

    thanks

    • I assume that you are referring to example 4.

      The question says ‘an amount equal to the amount of the tax allowable depreciation is required each year for the maintenance of non-current assets’. This is something that the current examiner has in most questions.
      Therefore although depreciation is not a cash flow and is added back, there is a cash outflow of the same amount. Therefore the net result is no effect.

      I do actually explain this in my lecture (because it is coming in the exam these days).

  15. Hi John

    Why has the revenue from royalties been included twice in the answer? The royalty revenues were initially converted into GBP in the earlier part of the answer, and then included again at their GBP amounts.

  16. Hi John, a rhetorical question, assume that the tax rate in UK is 18%, and there exists a double tax treaty between UK and Oblivia, in regard to James plc, the net cash surplus has been taxed in Oblivia at 20%, when calculating the net cash flows is there any tax credit of the excess 2% paid in Oblivia, to be included in the cash flows of James plc?? If yes, then why and if no, then why.

    Thanks, John 🙂

  17. OK so since we saved tax by deducting the TAD, why didn’t we include the tax savings as a positive inflow in our analysis? $1000 x 20% in year one for instance? because I remember you explaining this in F9.

  18. Hi,
    thank you very much for Your lectures they are very helpful.

    I have a question regarding example 4 and the amount payable each year for the maintenance of non-current asset and its treatment for profit or loss purposes.
    Could you please advise why they have not been included in calculation of profit? I thought they should be treated as an operating expense (I assume they have not been included in the “Operating costs” line as its amount exceeds the amount disclosed in that item).

    Thank you in advance for Your answer

    • You make a valid point. Most AFM questions rely on making assumptions, and if you state your assumptions then you would still get the marks (even though the final answer would be different).
      However, since the current examiner always makes the assumption that it is dealt with as I show in my lectures, it would be safest to always assume this 🙂

  20. Hello Sir Lectures are just amazing!
    Thing Am confused with is that why we are treating the royalties in both calculations.
    1) When calculating Net cash flows(NCF) in Euros
    2) When calculating (NCF) in pounds
    Why adjustments to be made in both calculations as the cash flows we’re converting from have been given the effect of royalty????
    Tax effect is understood

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