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Comments

  1. Hi, in the questions after the topic, the 1st one I don’t understand why you included the $10 for labor as relevant cost if they are already fully employed. In the lectures you didn’t include the $40000 labor costs as they were already employed.

    • This is actually revision from Paper PM relevant costing.

      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 lose 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.

  4. Thank you so much for your lecture. if we get the nominal rate is 13.3% we can use 13% df in the table, but what if its 13.78% can we use 14% or do we have to use fraction(1/1+r).
    Thank you.

  6. 1. Inflate the cash flows and you’d have to discount them at the actual/nominal cost of capital if you’re provided with it. If you aren’t, use the Fisher Formulae to determine the nominal cost of capital.

    2. If you don’t inflate them, you’d have to discount them at the effective interest rate/ real cost of capital.

    Understood!

  8. Hi john
    I’ve got the point that we would get the same NPV whether we discount real cash flows by the real cost of capital or the inflated cash flows by the inflated cost of capital, but in the example there is no scrap & tax savings, if there had been any of these in the question, then the NPV we would get by discounting at the real cost of capital would be higher than the NPV calculated using the nominal or inflated cost of capital.
    My question is that how will it affect our decision & should we discount the tax savings & scrap value at the rate of inflation, before including them in cash flows, while discounting at the real cost of capital(because both of them are future values), to get the same NPV?

    Secondly, as you said that in theory, the change in inflation rate doesn’t makes a difference to our decision as the cost of capital will change accordingly, resulting in same npv, but you focused that it is only in theory, why not its always the case
    practically?

    • The answer to both your points is that discounting the real cash flows at the real cost of capital only ‘works’ if all of the cash flows are inflating at the same general rate of inflation.

      In real life and in most exam questions, different cash flows are subject to different inflation rates and therefore we need to inflate the cash flows to get the actual/nominal cash flows and then discount at the actual/nominal cost of capital.

      • As in your example, a general rate of inflation is applied to all cash flows, for example:
        If there were tax payments & tax savings in the same question & we are required to calculate the NPV in real & nominal terms, in this case, applying tax rate on the real cash flows will result in lower tax payments than applying the tax rate on the nominal flows, but if we calculate tax savings due to capital allowances, they will be the same in both cases.
        My question is that why don’t we deflate the figures for tax savings, before including them in the calculation of NPV, using real rate?
        The reason i’m asking this, is that there is one such question in December 2013 exam.

      • The December 2013 question was a slightly silly question for the reasons you have stated. However the examiner did allow you to deflate the tax savings which is what effectively he did in the alternative approach that he showed in his answer.

  10. Wonderful lecture Sir. Just a small observation. If you just calculate 1.05/1.15 you get 9.13%, rounded to 9%. Then you discount at 2.531 and the NPV is +31.86 which is much closer to the initial +32.

  12. what will happen to the cash flows if they are different in each of the five years and these cash flows are before taken account of general inflation.
    eg yr 1=10000, yr2=15000, yr 3 17000 and so on. inflation is at the rate of 6.2%.
    Thanks

  14. Hi John,

    Just a quick question regarding inflation. Could he ever ask the question were prices are falling – i.e. deflation?

    just wondering because it is topical in Eurozone over the last couple of years and I know from other papers he does like to bring in current topics.

    Cheers.

    • Yes – he could have prices falling, but the approach would be exactly the same.

      (In fact F9 is not a topical exam and never has been. Also, apart from two tiny blips there has never been deflation in the Eurozone as a whole – low inflation certainly in recent years but not deflation (apart from the two blips) 🙂 )

  15. Dear Sir,

    You are kindly requested to response in my query below in regards to the question 5b of the inflation – effective rates:

    We have discounted the operating profit of $60 x 2.487 annuity rate ( but the cost of capital is 15% so 2.283 annuity) and then again, we discounted the NPV by the effective rate which includes both rates of inflation and cost of capital.

    I did not understand the logic and I have somehow stuck on this.

    Looking forward for your helpful reply.

    • I think maybe it would be helpful for you to watch the lecture again.

      Usually, we discount the actual (nominal) cash flows (i.e. after inflating them) by the actual (i.e. nominal) cost of capital.

      The alternative (which is very rarely relevant in the exam) is to discount the real cash flows (i.e. the current price flows, ignoring any inflation) at the real cost of capital (the effective rate, the cost of capital with inflation ‘removed’).

      In part (b) of the example, the real/effective cost of capital is 10% and therefore the 3 year annuity factor at 10% is correct at 2.487.

      However, it is very rarely in the exam that this is relevant (because, as I state in the lecture) it only works if all the cash flows inflate at the same general rate of inflation).

      Usually in the exam, you need to inflate the flows (to get the actual/nominal cash flows) and then discount them at the actual/nominal cost of capital.

  16. Hi John,

    Thank you so much for the easy to follow lecturers. I am however, worried that you do not seem to meantion the fishers equation in all your lectures relating to inflation yet nominal and real interest rates are a CONSTANT FEATURE of the exam. Can l assume that your formula on page 52 of the lecture notes(1+e=1+m/1+i) is the same as the Fisher equation. l have a textbook from BPP but would rather stick to Open Tuition(especially at this 11th hour) so please advise on this.

    Thanks

    • Although the examiner often (but certainly not always) refers to nominal and real costs of capital, it is overdoing it to regard it as a constant feature (or to regard it as a major part of the question)!

      I make it clear in the lecture that we always discount the actual/nominal cash flows at the actual/nominal cost of capital unless specifically told to do otherwise. (On only one occasion ever have you also been told as a separate part of the question, to also discount the real cash flows at the real cost of capital.)

      Otherwise the only relevance has been that on one or two occasions you have been given the real cost of capital and therefore needed to calculate the nominal cost of capital.
      Again, in the lecture I explain the reasoning and how to do this, and what to watch out for.

      (It is the Fisher formula, but you are right – I will update to use his symbols. He did not used to give the formula (and I think the symbols he uses are very odd 🙂 ) but it would be better if I used his symbols.)

  17. Dear John,

    Please I require some explanation on cash conversion cycle and the calculation of the ratios. I listened to your F9 lectures but I am still struggling to understand these.

    Inventory days = 15
    Receivable days =10
    Payable days = 14

    Cash conversion cycle is 11 days.

    This is how I interpret this, in 25 days I get cash, however the first 14 days out of the 25 days I have to pay out cash, so I still need to wait 11 days to get cash back? but I really still need to wait the whole 25 days to get back cash regardless of the fact that the first 14 days I pay out cash. Please help as I am really confused!

    Also for the ratios, say receivables days 24,000/50,000 (Receivables/Sales)This just tells me that receivables is 48% of total sales. when I multiply it by 365 days then what does that mean? I don’t see how it means it takes 175.2 days to collect sales. Rather, I interpret this as receivables are outstanding for 175.2 days out of the whole year.

    Please help explain from different angles, I’m sure I will get it once you explain vividly to me John M.

    Thank you for your assistance.

    • In future please post questions either under the relevant lecture, or (if you want me to answer) in the Ask ACCA Tutor forum for F9. This question has nothing to do with relevant cash flows for DCF.

      The operating cycle is the time that you are without the cash – i.e. the time between receiving the cash and paying out the cash.
      Our bank balance only falls when we pay out to buy the materials, which is in 14 days. The bank balance goes up again when we receive the cash from our customers from selling the goods, which is in 25 days. So we are without the cash for 11 days.

      If we have sales of 50,000, the the sales per day are 50,000/365.
      If the receivables are 24,000 at the end of the year, then it means we are owed for sales for 24,000 / sales per day. That comes to 175.2 days. So it means that we are allowing customers to take 175.2 days to pay us.

    • Fixed costs are only relevant if the total will change as a result of doing the project.
      Just absorbing or charging some of the costs to the new project (for profit purposes) is not relevant because it does not mean that the total is changing – it is just being shared differently.

  22. Hi ?john.I have a question about nominal rate of interest.It seems that the cost of capital given in the NPV question is the nominal rate of interest (is it?),then why the cost of capital given in the question doesn’t increase as the rate of inflation increase every year? THX John.

  23. in investment appraisal , we have to give tax payment on cashflows which are sales less variable cost less fixed cost , my question is , the scrap value should be added in the final year after the tax payment ? scrap value and working capital adjustments should be included after we made the tax payment ? kindly guide me , what would be the EXACT FORMAT of net present value /investment appraisal ?

    • The lecture on Relevant cash flows for tax gives the EXACT format.

      First we list the operating cash flows (sales less variable costs less incremental (extra) fixed costs)
      Then we calculate the tax on the operating flows.
      Then we list the capital flows (cost and scrap proceeds)
      Then we calculate the tax saving on the capital allowances (or ‘tax allowable depreciation’)
      Then we bring in the working capital flows (at the end, because they have no tax effect)

      • Thanks its really helpful , my another question is when calculating ROCE/ARR , we make operating cashflows (sales less variable cost less extra fixed cost) into accounting profit i.e operating cashflows less accumulated depreciation divided by projests life equals to accounting profit , right? my question is that whether to include scrap value in the operating cashflows too ?

  24. the discount rate /cost of capital given in the investment appraisal (in which we discount cashflows for present values) is a Nominal rate (money term) ? what basically it is ? nominal ? and is this a before tax or after tax cost of capital ? n my other question is if we r given general inflation so we have to convert Real into Nominal rate ? kindly make it clear . with exaples , it confuses me so much .

    • In F9 we always discount the actual (nominal) cash flows at the actual (nominal) after tax cost of capital.

      If the cash flows are given in real (current price) terms the we need to inflate them to get the actual (nominal ) cash flows.

      If the cost of capital is given in real terms ( the ‘real’ cost of capital) we need to use the formula (with the inflation rate) to get the actual (nominal) cost of capital.

      We always use the after tax cost of capital.

      For examples watch the lecture again and see the course notes.

  26. Hi John:
    Thanks for your lecture with such clarity. As it relates to inflation, June 2012 question # 1, how are the inflated selling and variable costs arrived at from years 2 to 4? we are given selling prices from years 1 to 4 being $25, $24, $23 & $23 with 4% inflation the answers given are $26 (ok), $25.96, $25.87, & $26.91. Variable cost given for years 1 to 4 are $10, $11, $12 & $12.50 at 2.5% inflation. answers given are $10.25 (ok), $11.56, 12.92 & $13.80.

    Thank you

  31. i study at india where there is a great lack for good teachers and i have just(4days) come to know of your videos and already am gonna complete watching all the sessions-they are so addictive which also means you are still to do a lot of marketing about these lectures but i can tell you they ll be more than just a soaring hit……………………!!!!!!!!!!!
    kudos u guys rock…………………
    the part when you said about bringing

    1.05/1.15 = 1/1.15/1.05 …..it hit the penultimate part of my understanding of the fischer’s formula…………

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