Just a quick question, if the question had stated that the fixed overheads are not absorbed and extra is needed, how will I treat that? is it the same principle as working capital in example 3?

Hi Just checking the fixed costs are already happening before the project starts so even the 20% that will be absorbed by the project, are classed as sunk costs?

Not really – the fixed costs will be payable in the future. However they are not relevant because they are not incremental costs of doing the project (they will be paid anyway).

I have a question regarding inflation. If we also had a general inflation rate on example number 5, how would we deal with inflation. would we inflate the material, labour and selling price twice? would we also inflate the overheads and other expenses as well with the general inflation rate?

No – if there is a specific rate given for a particular flow, then you only inflate at that rate. You would only apply the general rate to flows that you were told inflated at the general rate. (The general rate is like an average inflation rate and is only normally relevant for calculating the nominal rate when you now the real rate, and vice versa).

If this type of question comes up in the exam, will i get marks if i use excel formuls and do not show working like you did in this example 5. excel formula example, material inflation A1 inflation 108% A2 quantity 100,000 A3 cost $8 this would be as in year 1 =A1*A2*A3 answer will show= 864,000

Hi sir, if a project has an initial outflow followed by years of inflows, what would be the effect on the NPV and IRR of an increase in cost of capital and why would it happen? Thankyou

You must in future ask this sort of question in the Ask the Tutor Forum and not as a comment on a lecture 馃檪

However it should be clear to you from the other lectures (and the Paper F2 lectures on this, because it is revision of F2) that the IRR is independent of the cost of capital and therefore an increase in the cost of capital has no effect on the IRR. Also (again from the earlier lectures) it should be clear that the higher the cost of capital then the lower the NPV. Please do watch all of the lectures (and, if necessary, the relevant Paper F2 lectures).

Yes sir, I’ll keep that in mind from the next queries I have. But my doubt about the cost of capital not changing IRR is still not cleared as we take the lower cost of capital rate and higher cost of capital rate to calculate the IRR.

But we do not do that to calculate the IRR! We use any two ‘guesses’ at the interest rate in order to calculate the IRR. It just makes sense to use the cost of capital as one of the guesses if we have already had to calculate the NPV at the cost of capital. Again, I do suggest you watch the lectures on IRR, and if necessary the Paper F2 lectures on IRR. The IRR is (by definition) the rate of interest at which the NPV is zero, which is completely independent of the cost of capital.

sir I have a doubt in example 4 .Say if we proceed with the project we invest in the machine, then wont we buy the materials immediately and start production. So why are inflating price of material in 1 year time. i could understand it if investing in machine was also consider in 1 years time but we assume that m/c is purchased now (i.e in 0 year time) so materials should also be purchased now to start production.

We always assume that operating flows (such as sales revenue, purchases etc.) occur at the end of years unless told otherwise – so the first flow for material will be at time 1 and will have one years inflation.

In practice they are more likely to be purchased evenly throughout the year (and maybe inflate also evenly throughout the year) and the payment (which is what would be relevant) is likely to be sometime after the purchase. However that would make things very complicated (and be completely outside the scope of F9 (and P4) and so we always assume end of year.

There is no way they would buy inventory to last the whole year at the start of the year. They will obviously need to buy some goods at the start of the year, but this is effectively part of the working capital requirement.

The 401 is the operating cash flow, which is the profit before depreciation (i.e. the cash flow, which is what we need).

The capital allowance is another word for tax allowable depreciation (which you should understand from paper F6 or whatever you exempted you from F6).

For tax purposes the capital allowances reduce the tax payable, so although (as you can see from the printed answer in the lecture notes) there are two ways of arriving at the same answer, the easiest way is to calculate what the tax would be on the cash profits (i.e. the operating cash flows, the profit before depreciation) and then calculate separately the tax saving from the tax allowable depreciation (the capital allowances).

We are purchasing materials at the current price throughout the 1st year and then just paying for it at the end. We know the current price as it is given in the question. Then why inflation applies for time 1 (or 1st year) as we are purchasing the materials at current price in 1st year ?

But we have not yet decided whether or not to do the new project. So the first year of the project will be next year. The current price is the price we have been quoted this year.

Always in the exam, if you are given a figure at current prices then the actual cash in the first year will be with 1 years inflation, in the second year will be with 2 years inflation, and so on 馃檪

John, just out of curiosity i wanted to know what happens to the taxable amount in the last year? Because we just worked out till the balance allowance and 30% of 575 and we got the tax savings. But what was the actual taxable amount?

PS.Another amazing lecture video John! Thanks a bunch. Your explanation makes it very easy to understand the concepts.

I may have missed your explanation if this question was asked . We do not inflate year 1 sale price of 20 in your calculation but start inflating from year 2. All expenses are inflated from year 1. Bit confusing – even the question says the price of $20 in the first year I still do have this question – why the sale price is not inflated in year 1 ?

If the question says that the price will be $20 in the first year, then it will be $20. How can it inflate if we have decided to fix our initial selling price at $20?

With costs on the other hand, it is less likely that we will know what the cost will be in the first year (we haven’t even bought the machine now). What we will know is the current price, but by next year (the first year of the having the machine) then it will have inflated.

petriep says

Hi John,

Just a quick question, if the question had stated that the fixed overheads are not absorbed and extra is needed, how will I treat that? is it the same principle as working capital in example 3?

John Moffat says

If extra is needed then the extra amount is a cash outflow.

petriep says

Thank you.

John Moffat says

You are welcome 馃檪

loukasierides says

thank you Sir for a very helpful lecture. good thing i managed to do capital allowances in F6 before this and the previous lessons

John Moffat says

Thank you for your comment 馃檪

barbadoshk says

Hi

Just checking the fixed costs are already happening before the project starts so even the 20% that will be absorbed by the project, are classed as sunk costs?

John Moffat says

Not really – the fixed costs will be payable in the future. However they are not relevant because they are not incremental costs of doing the project (they will be paid anyway).

barbadoshk says

Ok thank you sir !

John Moffat says

You are welcome 馃檪

kjalali says

Hello Sir,

I have a question regarding inflation.

If we also had a general inflation rate on example number 5, how would we deal with inflation. would we inflate the material, labour and selling price twice? would we also inflate the overheads and other expenses as well with the general inflation rate?

thanks

John Moffat says

No – if there is a specific rate given for a particular flow, then you only inflate at that rate. You would only apply the general rate to flows that you were told inflated at the general rate. (The general rate is like an average inflation rate and is only normally relevant for calculating the nominal rate when you now the real rate, and vice versa).

suay says

hello,

If this type of question comes up in the exam, will i get marks if i use excel formuls and do not show working like you did in this example 5.

excel formula example, material inflation

A1 inflation 108%

A2 quantity 100,000

A3 cost $8

this would be as in year 1 =A1*A2*A3

answer will show= 864,000

Thank you

John Moffat says

If you are taking the computer based exam then the workings that the marker will look at will be the formulae in the spreadsheet.

samyuktha97 says

Hi sir, if a project has an initial outflow followed by years of inflows, what would be the effect on the NPV and IRR of an increase in cost of capital and why would it happen?

Thankyou

John Moffat says

You must in future ask this sort of question in the Ask the Tutor Forum and not as a comment on a lecture 馃檪

However it should be clear to you from the other lectures (and the Paper F2 lectures on this, because it is revision of F2) that the IRR is independent of the cost of capital and therefore an increase in the cost of capital has no effect on the IRR. Also (again from the earlier lectures) it should be clear that the higher the cost of capital then the lower the NPV. Please do watch all of the lectures (and, if necessary, the relevant Paper F2 lectures).

samyuktha97 says

Yes sir, I’ll keep that in mind from the next queries I have. But my doubt about the cost of capital not changing IRR is still not cleared as we take the lower cost of capital rate and higher cost of capital rate to calculate the IRR.

John Moffat says

But we do not do that to calculate the IRR! We use any two ‘guesses’ at the interest rate in order to calculate the IRR. It just makes sense to use the cost of capital as one of the guesses if we have already had to calculate the NPV at the cost of capital.

Again, I do suggest you watch the lectures on IRR, and if necessary the Paper F2 lectures on IRR.

The IRR is (by definition) the rate of interest at which the NPV is zero, which is completely independent of the cost of capital.

samyuktha97 says

Okay Sir, now I understood it! Thank you so much for your timely reply 馃檪

John Moffat says

You are welcome 馃檪

rakhi2rakhi says

sir I have a doubt in example 4 .Say if we proceed with the project we invest in the machine, then wont we buy the materials immediately and start production. So why are inflating price of material in 1 year time. i could understand it if investing in machine was also consider in 1 years time but we assume that m/c is purchased now (i.e in 0 year time) so materials should also be purchased now to start production.

John Moffat says

We always assume that operating flows (such as sales revenue, purchases etc.) occur at the end of years unless told otherwise – so the first flow for material will be at time 1 and will have one years inflation.

In practice they are more likely to be purchased evenly throughout the year (and maybe inflate also evenly throughout the year) and the payment (which is what would be relevant) is likely to be sometime after the purchase. However that would make things very complicated (and be completely outside the scope of F9 (and P4) and so we always assume end of year.

There is no way they would buy inventory to last the whole year at the start of the year. They will obviously need to buy some goods at the start of the year, but this is effectively part of the working capital requirement.

JR says

Dear John,

I am confused when you mentioned about the first year profit $401 then deduct it with the first year CA of $700. what does it mean?

John Moffat says

The 401 is the operating cash flow, which is the profit before depreciation (i.e. the cash flow, which is what we need).

The capital allowance is another word for tax allowable depreciation (which you should understand from paper F6 or whatever you exempted you from F6).

For tax purposes the capital allowances reduce the tax payable, so although (as you can see from the printed answer in the lecture notes) there are two ways of arriving at the same answer, the easiest way is to calculate what the tax would be on the cash profits (i.e. the operating cash flows, the profit before depreciation) and then calculate separately the tax saving from the tax allowable depreciation (the capital allowances).

Laiq Hussain says

We are purchasing materials at the current price throughout the 1st year and then just paying for it at the end. We know the current price as it is given in the question. Then why inflation applies for time 1 (or 1st year) as we are purchasing the materials at current price in 1st year ?

John Moffat says

But we have not yet decided whether or not to do the new project. So the first year of the project will be next year. The current price is the price we have been quoted this year.

Always in the exam, if you are given a figure at current prices then the actual cash in the first year will be with 1 years inflation, in the second year will be with 2 years inflation, and so on 馃檪

Laiq Hussain says

Thank you very much. It is clear now.

John Moffat says

You are welcome 馃檪

ashishhegde says

John,

just out of curiosity i wanted to know what happens to the taxable amount in the last year?

Because we just worked out till the balance allowance and 30% of 575 and we got the tax savings.

But what was the actual taxable amount?

PS.Another amazing lecture video John!

Thanks a bunch.

Your explanation makes it very easy to understand the concepts.

John Moffat says

The actual taxable amount is the operating profit less the balance allowance.

Easier in F9 is to calculate the tax on the operating profit and the sax saving on the allowance separately.

(And thank you for the comment 馃檪 )

ashishhegde says

Thanks John 馃檪

My exam is in 2 weeks.

Wish me luck! 馃榾

Cheers! 馃檪

And keep up the good work.

kelkar says

John

I may have missed your explanation if this question was asked . We do not inflate year 1 sale price of 20 in your calculation but start inflating from year 2.

All expenses are inflated from year 1.

Bit confusing – even the question says the price of $20 in the first year I still do have this question – why the sale price is not inflated in year 1 ?

thanks

John Moffat says

If the question says that the price will be $20 in the first year, then it will be $20. How can it inflate if we have decided to fix our initial selling price at $20?

With costs on the other hand, it is less likely that we will know what the cost will be in the first year (we haven’t even bought the machine now). What we will know is the current price, but by next year (the first year of the having the machine) then it will have inflated.