Sir, in example 1, the working capital is assumed to be recovered back at the end of the project. Looking at this question, it mentions that the machinery would be sold at the end of the year and is not giving any indication of the project ending in the 5th year.

So can we use an assumption that since the project deadline isn’t given, the working capital would be considered invested even after the 5th year and not include 200 inflow in the final year?

You could, but in P4 the examiner always recovers the working capital (unless he has specifically said differently in the question).

However, P4 investment appraisal questions always ask for you to state your assumptions, so as long as you do state the assumption then there is no problem 🙂

Do I understand correctly that in questions like in Example 1 we always assume that all the income and expenses are cashflows? My doubt is that in real life for example sales revenue normally never matches to cash receipts from these sales – cash normally recieved on a later date and AR are posted as assets at the moment of sale…

Yes – we make that assumption.
(It seems from your questions that you are ‘jumping’ around the lectures – I do suggest that you watch them in order 🙂 )

Working capital is money needed to finance having to accept higher receivables, higher inventories etc..

Therefore it is likely that there will be extra outflows of cash to cover this during the life of the project.

At the end of the project we assume that we no longer need extra receivables etc. and so the money is released – we get back all of the working capital previously invested.

The relevant free lectures for Paper F9 on relevant cash flows for investment appraisal will help you – P4 is exactly the same as F9 in this respect.

Sir i dint understand why you ignored the fixed cost and yet the management accountant decided that 20% of $1000 should be absorbed into the new product.

Absorbing means charging. For profit purposes fixed overheads can be charged to different products any way we want. However for DCF we are only interested in extra cash flows incurred by the company. Simply deciding to split the overheads differently does not mean that the total fixed overheads of the company will change. If the total does not change then there is no additional cash flow.

It may help you to watch the Paper F9 lectures on this.

I just got little bit confused regarding two things, please correct me if am wrong

a) In the example 1 above, was it assumed the materials were bought at the end of 1st year, such that they were inflated upto end of 1st year? If this is so how come there were sales at the year one, does this mean all sales occured at the year end?

b) Regarding gearing, can we say that gearing is unsystematic risk, because it is company specific it may vary between different companies and because of this there is no need to include in beta, can we assume it may be eliminated by diversification?

In future, I will be grateful if you can ask this sort of question in the Ask the Tutor Forum rather than as a comment on a lecture 🙂

In answer to (a):

The production costs are quoted at current prices. The rule is that if costs are quoted at current prices then the cost in 1 years time will be higher because of inflation.
The logic behind this is that if you are thinking of buying this new machine, then you are likely to get quotes regarding the cost of materials etc now (even though you have not yet bought the machine). However, you will not be actually incurring the cost until next year and so by next year the cost quoted (at current prices) will have increased because of inflation.
With regard to the selling price, the question specifically says that they will be sold at $20 per unit in the first year, and so it is only in later years that the cash price will be increased.

In answer to (b):
Gearing is not unsystematic risk. The effect of gearing it to increase the existing risk of the business, whether it be systematic or unsystematic. If the earnings were certain (so no risk) then gearing would have no effect on the risk to shareholders because the dividends would be certain also. Obviously in practice, the earnings are subject to risk (both systematic and unsystematic) and the affect of gearing is to increase the level of risk when it comes to dividends (and therefore for shareholders).

If I am not making this clear, then you will find it helpful to watch the F9 lecture on gearing risk where I go through an example to explain exactly how gearing increases the existing risk in the business.

I really appreciate for your quick response Mr Moffat, i now got the concept very clearly. I apologize for the mistake regarding posting questions in the comments section rather than posting it in the Ask the Tutor Forum.
Thanks once again.

I don’t understand your question (this place is for commenting on the lecture – if you have a specific question then you should ask it in the Ask the Tutor Forum).

What about the answers?
They are on the ACCA website.

Again in calculating discount factors, well if you want to calculate the discount factor of year 2 to infinity at a cost of capital of 14%, you take the perpetuity of 7.143 multiplied by the DF of year 2 of 0.769 to get 5.493, correct me of I’m wrong.

Now when it comes to let’s say FCFE growing at 3% from year 4 to infinity then calculating the DF you take 1/(14%-3%)*DF of year 3, well my question is why not multiplying by the DF of year 4? Please explain to me the logic I’m getting confused.

To the same question if there was no growth rate and FCFE remained constant yeah i knw we wouldnt b deducting the growth rate but what would be the discount factor to the same scenario?

You are wrong (and I explained this to you a week ago – below)

For 2 to infinity you take the discount factor for a perpetetuity and multiply by the one year factor because it starts 1 year late (it starts at time 2 instead of time 1).

For 4 to infinity you take the discount factor for 1 to infinity and multiply by the 3 year discount factor because it starts 3 years late (it starts at time 4 instead of time 1)

What are the different ways of calculating the discount factor of, for example, year 3-15 at a cost of capital of 11%?
I tried taking the annuity of year 1-15 then subtracted the annuity of year 1-2, is this method acceptable?
Another method I tried was taking the annuity of year 1-15 then multiplied with the present value discount factor of year 2, correct me if I’m wrong.
Thank you.

Either method is acceptable.
However, you have made a mistake in your second method. If it is 3 to 15, then there are 13 years of flows. Therefore you should take the annuity factor for 13 years and then multiply by the present value factor for 2 years.

Both methods will give the same answer (apart from rounding, which is irrelevant in the exam).

You look up 0.7 down the left hand side, and then 0.07 across the top.

This should give you 0.2794.

Then you apply the rule at the bottom of the tables.
Here, because D1 is >0, you add 0.5 to the figure from the tables.
so N(D1) = 0.5 + 0.2794 = 0.7794

Sir is Business valuation covered in the audio lectures . And if yes , please guide me where to find them . And secondly post acquisition change is share price and the premium calculations , please guide me where to find them in your audio lectures.
Thank you.

There is this ongoing issue with Fixed Costs, well not really ongoing but how BPP solved the problem below is bit confusing to me.

BPP Practice and Revision Kit ( Mock Exam 2, Q1). It is an International Investment Appraisal question. One of the information said and i quote

“Fixed Costs and local variable costs, which for the first year of operation are 12 million pesos and 600 pesos per unit respectively, are expected to increase by the previous year’s rate of inflation”.

My interpretaion from the above means both costs are to increase ? so fixed costs will increase?

BUT the answer only uses variable costs and ignored fixed costs.

Please any explanation why this was the case or should I just state my own assumptions in the exam and work with that. I know.

Feedback s are highly appreciated. I just need to pass this P4 this time

I do not have the BPP mock, but the reason will almost certainly be because fixed costs are only relevant if the total fixed costs increase as a result of doing the project. For profit purposes they may well absorb them over different projects, but for DCF we are only interested if the total fixed costs change.

Please forum/Tutor, can someone help me with the correct treatment of tax allowable depreciation.

In some solutions, it forms part of the cashflows before tax and after the tax is calculated, it is added back to the After tax cashflow.

However in Some other answers, what is done is this. They calculate the capital allowance and get the tax effect on the allowance calculated and this is added to the cashflows after tax and if it is a balancing charge the effect is a deduction. So which is the correct treatment

If the fixed overheads are 20 in the first year and grow at 10% per year each year, then they will be 22 in the second year, and so on……..your answer (ii).

I don’t know why you have called them incremental changes at all. There would be no logic whatsoever in your answer (i)
(Just suppose you personally pay rent of 20 a year, and I tell you it will increase at 10% a year – it will not mean you pay 42 next year!!!!)

Separately though, do remember that fixed overheads are only relevant at all if they are extra (incremental) fixed overheads as a result of doing the project. If they are going to be payable anyway then they are not relevant.

It really depends on assumptions, and whether or not you are told the value of the project at the end of the planning period. Sometimes the examiner has treated the value at the end as if they were sale proceeds (and therefore had a balancing charge/allowance), other times it has just been reducing balance for each year of the planning period. On at least one occasion the problem has been avoided by the question giving the after-tax value, which assumed it had dealt with all taxes.

If it is not made clear then state your assumption and you will get the marks. In P4 there is rarely one correct answer – it depends often on assumptions made (not just with regard to tax).

I’m not getting you. I’m asking, if at the end of a project for e.g 6th year, after charging capital allowance that year, if there still remains some balance and no sale proceeds are given, so will we calculate any unrecovered allowance on it by multiplying with the tax rate?

Every year it is a writing down allowance of 25% reducing balance except for the final year.
In the final year, there is no writing down allowance. Instead you subtract any sale proceeds from the written down value and the difference is a balancing allowance or a balancing charge – that is the capital allowance in the final year.

Hi
With regards this tutorial, why is it that no tax benefit is associated with the asset in the year it is disposed? I would have expected a tax benefit of 570 *0.25*0.25 (balance at end of year 4 x charge for year 5 x tax effect of charge for year 5). Please assist!

No – the only tax effect when a non-current asset is sold is the tax on the balancing charge or allowance (as is in the lecture).

(Ignore this bit if it confuses, but the point is that you are allowed to get a total tax saving of 25% (the tax rate) of the total drop in value of the asset – in this case it drops in value by 800 (1800 cost less 1000 sale proceeds) and so the total tax saving will be 25% x 800 = 200. However, year by year you get the saving on a reducing balance basis, and then in the final year there is the balancing charge or allowance which makes the overall total tax saving equal to the 200. If you add up all the tax benefits over the years, then it does come to a total of 200 (subject to roundings))

Thanks. I get this. What I don’t understand is why there was no capital allowance in the year of disposal. Is the disposal presumed to occur at the start of the year? If so should we not do away with revenues and costs in the year of disposal? The calculation of the balancing charge clearly assumes there is no capital allowance in the year of disposal and I want to understand why this assumption is made. I hope clarifies my question.

The rule for the capital allowance calculation is that it is 25% reducing year for every year except the final year. In the final year there is either a balancing allowance or a balancing charge depending on the amount of the sale proceeds. It has nothing to do with when the asset is sold during the year.
(A balancing allowance is a capital allowance, a balancing charge is simply a negative allowance)

(That is the rule, although in fact even if it was allowed to have 25% in the final year it would end up with the same result – all that would happen is that the balancing charge or allowance would change, but the net result would be exactly the same )

I actually mean the interest rate for borrowing pounds, The interest rate of 5.5% is for up to 6 months, Which according to the answer was 0.08333 which I don’t know how they got it.

Either you have misread the answer or there is a typing error.

The interest rate for depositing dollars for 5 months is 5/12 x 2% which equals 0.833% (or 0.00833).
The interest rate for borrowing pounds is 5/12 x 5.5% which is 2.29% (or 0.0229)

Hi sir
Thanks for the lectures, I have one question to ask, Its from December 2008 Exams Question one (BLIPTON), I real don’t know how Project operating cash flow (Nominal) is calculated at the return Phase.

I guess you are clear as to how the real cash flows have been calculated – these are the cash flows ignoring inflation. (If you are not clear about any of them then do post again).

The nominal cash flows are the actual cash flows – i.e. taking account of the inflation (which in the UK is 2.5% per annum.

So…….the first cash flow is $52,000 in real terms, but this is received 2 years after the start of the project and so we need to add on 2 years inflation. 52,000 x (1.025^2) = 54,633
Similarly, the second cash flow is 490,000 in real terms, but is received at time 3 and so we need three years inflation at 2.5% per annum. 490,000 x (1.025^3) = 527676

@toobaalvi in as close to a lay man explanation as i can, i understand or treat so i understand working capital to mean its like pettycash. ie you already have taxable income from your sales, and you are told you need to have a buffer cash set aside for incidentals and is readily availed towards the project hence you would have already paid the tax for the same money when you received it as revenue etc. or from the source you raised it with.

The Tutor will answer both of us with a better answer, it just helps me to think of it that way!

To be honest it does not matter how you think about it provided that you accept that there will be no tax implications, and that (unless you are told otherwise) you will get it all back at the end of the project.

(Although it is not really petty cash – it is money to finance extra receivables and extra inventory. These would not affect the tax liability, and at the end of the project you no longer need to finance extra receivables etc and so you get the money back 🙂 )

@Cara you meant for Accounting rate of return, thats when you need taxable profit and all. However the Tutor will correct me if iam wrong, it seems P4 (atleast from what i have covered to date assumes that to be carry forward knowledge hence it does not cover that revision, but that does not mean its irrelevant to do it .

2. I also wanted to make an observation on the 20% Fixed Overheads, that statement can be confusing in the exam, i know by now we understand irrelevant vis a vis relevant costs in decision making, and that it then means whether this project is embarked on or not the company will still pay the $1000,000. But once the question says ‘should be absorbed ‘ it tends to imply they arise because of the project and could have been avoided etc. (thats the confusion to watch out for)

The other one is for tax (Payed immediately or one year later ! the later one implies we add for the above example another year 6! as for the (Current prices of inflation! this information are a must to watch out for in the exam!) especially during the reading hours highlight them and scribble what effect they should have e.g whether you start the inflation in year 1 or after year 1.

Otherwise it would indeed be a welcome gift to get such a straight forward question in an exam setting!

@Cara i remember thats what my lecture also said for F9 i think then we used to get instances where we had to do an accounting rate of return or something, The syllabus i have covered for P4 i havent seen it touched as a method to use in evaluating investments, In any case when explained we have been mostly made aware of its shortcomings as a basis for appraisal method for a projects. as compared to NPV and IRR.

Admin, I missed the part on why we are not using the 20% Fixed Overheads, i do remember from my previous study though that certain costs are irrelevant in decision making because whether you take on the project or not you still incur them. So is the same logic applied here?!

2. I will practice more examples i have noticed if ever we get an easy question like this one we would be lucky in the exam as the examiner seems to enjoy confusing us by throwing in all concepts in one question esp the compulsory section. Sometimes i really feel, what is important is really not the numbers but understanding the concept enough to apply it in real life situations. As this type of questions can just take too much of the exam time! in future the answer sheets should have the templates in advance! Whew.

may i know the timing we should start to claim capital allowance?
from my understanding, if we incurred capital expenditure in year 0, we should claim capital allowance in year 1 unless the question state otherwise. But, should i apply the same concept if first year allowance is given in the question?

If you watch the lecture it makes it clear (and if necessary watch the relevant F9 lectures).

However, in P4 do not worry too much about the timing – it depends on assumptions (as does so much of P4). If you state your assumptions then you will get the marks (provided obviously that they are sensible assumptions 🙂 )

can we tear out the formula sheet, the present value table and the annuity table during the exam time, so that its earsier for us to see the rate and save up time,no need to flip the question booklet many times.

thank you for this lecture , again very well explained 🙂 I have one question in relation to NPV. I just looked in my notes from F9, and my lecturer then ask us in calculation of NPV first include capital allowances in calculation of taxable profit than calculate and deduct tax and than add capital allowances back. So the tax effect is at the end the same as in NPV which you presented. I remember that my lecturer justified this approach because taxable profit which include capital allowances was needed in the calculation of something else, and well I don’t remember now where did we use it. Could you please tell me where we we can use such a profit, and if it will be used in the calculation in P4

For F9 it does not matter which way you deal with the capital allowances. The answer will be the same whichever way.
For P4, the same usually applies. The only thing at P4 is that in one question it was the case that if there was a taxable loss, then it was made clear that you could not offset it against other profits (and therefore not simply get a tax saving) but that the losses were carried forward.
However, to be honest it is best you leave worries about that until P4 – for F9 it does not matter which way you do it. Whichever way you find the easiest to remember 🙂

In the NPV (e.g 1) question we inflated the sales and costs at different inflation rates, which essentially mean that we considered the nominal cash flows. In that case, aren’t we supposed to consider the nominal rate as well which is the real rate inflated at the general inflation?

However, the nominal cost of capital is the actual cost of capital. Since all the question says is that the cost of capital is 10% we must assume that it is the actual (i.e. nominal) cost of capital. We would always assume this unless we were specifically told the ‘real’ cost of capital.

(Additionally, since the question does not give the general rate of inflation, the again we have to assume that the cost of capital given is the actual WACC i.e. the nominal rate.)

Fixed overheads are only relevant if the total fixed overheads for the company increase.

If the questions simply says that some of the overheads are allocated to the project, it does not mean that the total expenditure changes.

(The point is that for profit purposes a company change split the overheads between projects any way that they want to, but again, the total cash flow for the company only changes if the total fixed overhead bill changes.)

Hemraj says

Sir, in example 1, the working capital is assumed to be recovered back at the end of the project. Looking at this question, it mentions that the machinery would be sold at the end of the year and is not giving any indication of the project ending in the 5th year.

So can we use an assumption that since the project deadline isn’t given, the working capital would be considered invested even after the 5th year and not include 200 inflow in the final year?

John Moffat says

You could, but in P4 the examiner always recovers the working capital (unless he has specifically said differently in the question).

However, P4 investment appraisal questions always ask for you to state your assumptions, so as long as you do state the assumption then there is no problem 🙂

Hemraj says

Thanks a lot, sir! 🙂

John Moffat says

You are welcome 🙂

Amer says

Hey, John, could you answer my question in the “Ask Tutor Forum”?

Thank You

John Moffat says

Sorry – I must have missed it. Will do 🙂

abdelbagi2004 says

very helpful and clear lectures thaks Jhon

John Moffat says

Thank you for the comment 🙂

phylisgathoni says

Thank you .It was quite comprehensive

jia says

kindly ignore this query here as a comment because i posted it in ask the tutor forum.

Ivan says

Sir,

Do I understand correctly that in questions like in Example 1 we always assume that all the income and expenses are cashflows? My doubt is that in real life for example sales revenue normally never matches to cash receipts from these sales – cash normally recieved on a later date and AR are posted as assets at the moment of sale…

John Moffat says

Yes – we make that assumption.

(It seems from your questions that you are ‘jumping’ around the lectures – I do suggest that you watch them in order 🙂 )

Ivan says

Thank you sir! I will follow your recommendation.

rowetigere says

Please help me understand the treatment of working capital.especially on the part were u said it has to be released

John Moffat says

Working capital is money needed to finance having to accept higher receivables, higher inventories etc..

Therefore it is likely that there will be extra outflows of cash to cover this during the life of the project.

At the end of the project we assume that we no longer need extra receivables etc. and so the money is released – we get back all of the working capital previously invested.

The relevant free lectures for Paper F9 on relevant cash flows for investment appraisal will help you – P4 is exactly the same as F9 in this respect.

rowetigere says

Thank you very much sir

ireengonwe says

Sir i dint understand why you ignored the fixed cost and yet the management accountant decided that 20% of $1000 should be absorbed into the new product.

John Moffat says

Absorbing means charging. For profit purposes fixed overheads can be charged to different products any way we want. However for DCF we are only interested in extra cash flows incurred by the company. Simply deciding to split the overheads differently does not mean that the total fixed overheads of the company will change. If the total does not change then there is no additional cash flow.

It may help you to watch the Paper F9 lectures on this.

ireengonwe says

Thanks i have understand now that we only concentrate on the extra charge.

Samson says

How can i download the video lecture for P4?

John Moffat says

Lectures cannot be downloaded – they can only be watched online.

It is the only way that we can keep this website free of charge.

sogan0 says

Thank You for the lecture

SOUD SAEED says

Hello Sir,

I just got little bit confused regarding two things, please correct me if am wrong

a) In the example 1 above, was it assumed the materials were bought at the end of 1st year, such that they were inflated upto end of 1st year? If this is so how come there were sales at the year one, does this mean all sales occured at the year end?

b) Regarding gearing, can we say that gearing is unsystematic risk, because it is company specific it may vary between different companies and because of this there is no need to include in beta, can we assume it may be eliminated by diversification?

Thanks,

Soud Said.

John Moffat says

In future, I will be grateful if you can ask this sort of question in the Ask the Tutor Forum rather than as a comment on a lecture 🙂

In answer to (a):

The production costs are quoted at current prices. The rule is that if costs are quoted at current prices then the cost in 1 years time will be higher because of inflation.

The logic behind this is that if you are thinking of buying this new machine, then you are likely to get quotes regarding the cost of materials etc now (even though you have not yet bought the machine). However, you will not be actually incurring the cost until next year and so by next year the cost quoted (at current prices) will have increased because of inflation.

With regard to the selling price, the question specifically says that they will be sold at $20 per unit in the first year, and so it is only in later years that the cash price will be increased.

In answer to (b):

Gearing is not unsystematic risk. The effect of gearing it to increase the existing risk of the business, whether it be systematic or unsystematic. If the earnings were certain (so no risk) then gearing would have no effect on the risk to shareholders because the dividends would be certain also. Obviously in practice, the earnings are subject to risk (both systematic and unsystematic) and the affect of gearing is to increase the level of risk when it comes to dividends (and therefore for shareholders).

If I am not making this clear, then you will find it helpful to watch the F9 lecture on gearing risk where I go through an example to explain exactly how gearing increases the existing risk in the business.

SOUD SAEED says

I really appreciate for your quick response Mr Moffat, i now got the concept very clearly. I apologize for the mistake regarding posting questions in the comments section rather than posting it in the Ask the Tutor Forum.

Thanks once again.

Soud Said.

P4 says

Answers for P4 December 2014? (This attempt)

John Moffat says

I don’t understand your question (this place is for commenting on the lecture – if you have a specific question then you should ask it in the Ask the Tutor Forum).

What about the answers?

They are on the ACCA website.

Fatma says

Again in calculating discount factors, well if you want to calculate the discount factor of year 2 to infinity at a cost of capital of 14%, you take the perpetuity of 7.143 multiplied by the DF of year 2 of 0.769 to get 5.493, correct me of I’m wrong.

Now when it comes to let’s say FCFE growing at 3% from year 4 to infinity then calculating the DF you take 1/(14%-3%)*DF of year 3, well my question is why not multiplying by the DF of year 4? Please explain to me the logic I’m getting confused.

Fatma says

To the same question if there was no growth rate and FCFE remained constant yeah i knw we wouldnt b deducting the growth rate but what would be the discount factor to the same scenario?

Any assistance would highly be appreciated.

John Moffat says

To discount a growing FCFE you use the dividend growth formula from the formula sheet.

John Moffat says

You are wrong (and I explained this to you a week ago – below)

For 2 to infinity you take the discount factor for a perpetetuity and multiply by the one year factor because it starts 1 year late (it starts at time 2 instead of time 1).

For 4 to infinity you take the discount factor for 1 to infinity and multiply by the 3 year discount factor because it starts 3 years late (it starts at time 4 instead of time 1)

Fatma says

Thanks a lot sir. Well different books confused me but now i can clearly get the concept.

I also appreciate your fast response.

Fatma says

What are the different ways of calculating the discount factor of, for example, year 3-15 at a cost of capital of 11%?

I tried taking the annuity of year 1-15 then subtracted the annuity of year 1-2, is this method acceptable?

Another method I tried was taking the annuity of year 1-15 then multiplied with the present value discount factor of year 2, correct me if I’m wrong.

Thank you.

John Moffat says

Either method is acceptable.

However, you have made a mistake in your second method. If it is 3 to 15, then there are 13 years of flows. Therefore you should take the annuity factor for 13 years and then multiply by the present value factor for 2 years.

Both methods will give the same answer (apart from rounding, which is irrelevant in the exam).

Fatma says

Really much appreciate your help.

jidep2acca says

Hello Sir,

Could you help understand how to make use of the normal distribution table to get D1 N(0.77) and D2 N(0.63)…. Thank you.

John Moffat says

You look up 0.7 down the left hand side, and then 0.07 across the top.

This should give you 0.2794.

Then you apply the rule at the bottom of the tables.

Here, because D1 is >0, you add 0.5 to the figure from the tables.

so N(D1) = 0.5 + 0.2794 = 0.7794

It is the same procedure for N(D2)

shahnawaz says

Sir is Business valuation covered in the audio lectures . And if yes , please guide me where to find them . And secondly post acquisition change is share price and the premium calculations , please guide me where to find them in your audio lectures.

Thank you.

John Moffat says

No – there are no lectures on these chapters.

lakeside says

Dear All/Tutor,

There is this ongoing issue with Fixed Costs, well not really ongoing but how BPP solved the problem below is bit confusing to me.

BPP Practice and Revision Kit ( Mock Exam 2, Q1). It is an International Investment Appraisal question. One of the information said and i quote

“Fixed Costs and local variable costs, which for the first year of operation are 12 million pesos and 600 pesos per unit respectively, are expected to increase by the previous year’s rate of inflation”.

My interpretaion from the above means both costs are to increase ? so fixed costs will increase?

BUT the answer only uses variable costs and ignored fixed costs.

Please any explanation why this was the case or should I just state my own assumptions in the exam and work with that. I know.

Feedback s are highly appreciated. I just need to pass this P4 this time

Thanks

John Moffat says

I do not have the BPP mock, but the reason will almost certainly be because fixed costs are only relevant if the total fixed costs increase as a result of doing the project. For profit purposes they may well absorb them over different projects, but for DCF we are only interested if the total fixed costs change.

lakeside says

That makes sense then, so only incremental fixed cost because of the project and not because of general inflation, Thanks

ALI says

Can any one provide me solution of paper strategic financial management 3.7 of december 2006 of ACCA………?

lakeside says

Please forum/Tutor, can someone help me with the correct treatment of tax allowable depreciation.

In some solutions, it forms part of the cashflows before tax and after the tax is calculated, it is added back to the After tax cashflow.

However in Some other answers, what is done is this. They calculate the capital allowance and get the tax effect on the allowance calculated and this is added to the cashflows after tax and if it is a balancing charge the effect is a deduction. So which is the correct treatment

Many Thanks

John Moffat says

You can do it either way – both give the same net cash flow.

I prefer the second way (as you will have seen in my lecture) it is easier and safer.

lakeside says

Thanks a lot, that was very helpful John

prateshramjohn says

If the question said that the Fixed Overheads will grow from year one at a rate of 10%. What will be our charges to put into the NPV calculations?

Will it be:

i) yr 1= 20

yr 2= 42

yr3=66

yr4=93

yr5=122

or will it be incremental changes

ii) yr1 = 20

yr2=22

yr3=24

yr4=27

yr5=29

Thanks.

John Moffat says

If the fixed overheads are 20 in the first year and grow at 10% per year each year, then they will be 22 in the second year, and so on……..your answer (ii).

I don’t know why you have called them incremental changes at all. There would be no logic whatsoever in your answer (i)

(Just suppose you personally pay rent of 20 a year, and I tell you it will increase at 10% a year – it will not mean you pay 42 next year!!!!)

Separately though, do remember that fixed overheads are only relevant at all if they are extra (incremental) fixed overheads as a result of doing the project. If they are going to be payable anyway then they are not relevant.

prateshramjohn says

thanks alot.

toobaalvi says

Do we always claim unrecovered allownance on the balance left in the pool? and consequently the tax benefit on it?

John Moffat says

We cannot deal with a pool in P4 questions, and so we treat as a special item and have a balancing charge or balancing allowance if it is sold.

toobaalvi says

If the assets are not sold by the end of project, then what will we do with the balancing amount?

John Moffat says

It really depends on assumptions, and whether or not you are told the value of the project at the end of the planning period. Sometimes the examiner has treated the value at the end as if they were sale proceeds (and therefore had a balancing charge/allowance), other times it has just been reducing balance for each year of the planning period. On at least one occasion the problem has been avoided by the question giving the after-tax value, which assumed it had dealt with all taxes.

If it is not made clear then state your assumption and you will get the marks. In P4 there is rarely one correct answer – it depends often on assumptions made (not just with regard to tax).

toobaalvi says

So will we calculate any charge or allowance if ‘it has just been treated as reducing balance for each year of the planning period’?

John Moffat says

That is not what I wrote.

You will always have capital allowances during the appraisal period at reducing balance!

toobaalvi says

I’m not getting you. I’m asking, if at the end of a project for e.g 6th year, after charging capital allowance that year, if there still remains some balance and no sale proceeds are given, so will we calculate any unrecovered allowance on it by multiplying with the tax rate?

John Moffat says

The way capital allowances work is this:

Every year it is a writing down allowance of 25% reducing balance except for the final year.

In the final year, there is no writing down allowance. Instead you subtract any sale proceeds from the written down value and the difference is a balancing allowance or a balancing charge – that is the capital allowance in the final year.

toobaalvi says

And if no sales proceeds are given then what will we do?

emereole says

Hi

With regards this tutorial, why is it that no tax benefit is associated with the asset in the year it is disposed? I would have expected a tax benefit of 570 *0.25*0.25 (balance at end of year 4 x charge for year 5 x tax effect of charge for year 5). Please assist!

emereole says

this i mean before we make a determination of whether there should be a balancing allowance or charge and the tax effect thereof.

John Moffat says

No – the only tax effect when a non-current asset is sold is the tax on the balancing charge or allowance (as is in the lecture).

(Ignore this bit if it confuses, but the point is that you are allowed to get a total tax saving of 25% (the tax rate) of the total drop in value of the asset – in this case it drops in value by 800 (1800 cost less 1000 sale proceeds) and so the total tax saving will be 25% x 800 = 200. However, year by year you get the saving on a reducing balance basis, and then in the final year there is the balancing charge or allowance which makes the overall total tax saving equal to the 200. If you add up all the tax benefits over the years, then it does come to a total of 200 (subject to roundings))

emereole says

Thanks. I get this. What I don’t understand is why there was no capital allowance in the year of disposal. Is the disposal presumed to occur at the start of the year? If so should we not do away with revenues and costs in the year of disposal? The calculation of the balancing charge clearly assumes there is no capital allowance in the year of disposal and I want to understand why this assumption is made. I hope clarifies my question.

John Moffat says

The rule for the capital allowance calculation is that it is 25% reducing year for every year except the final year. In the final year there is either a balancing allowance or a balancing charge depending on the amount of the sale proceeds. It has nothing to do with when the asset is sold during the year.

(A balancing allowance is a capital allowance, a balancing charge is simply a negative allowance)

(That is the rule, although in fact even if it was allowed to have 25% in the final year it would end up with the same result – all that would happen is that the balancing charge or allowance would change, but the net result would be exactly the same )

emereole says

Thanks John, I see what you mean.

christopheryaheya says

Hi Sir,

Consider this. $US/Sterling

Spot 1.9456-1.9210

3 Months Forward 1.9066-1.9120

1 year Forward 1.8901-1.8945

Borrowing Investing

Sterling up to 6 months 5.5% 4.2%

Dollar up to 6 months 4.0% 2.0%

We need to pay $1,150,000 in 5 months time, What will be the interest rate for borrow an equivalent pound now for.

John Moffat says

I don’t know what you mean by ‘equivalent’ pound.

However the interest rate for borrowing pounds is 5.5% per year, and so the interest for 5 months borrowing will be 5/12 x 5.5%.

christopheryaheya says

I actually mean the interest rate for borrowing pounds, The interest rate of 5.5% is for up to 6 months, Which according to the answer was 0.08333 which I don’t know how they got it.

John Moffat says

Either you have misread the answer or there is a typing error.

The interest rate for depositing dollars for 5 months is 5/12 x 2% which equals 0.833% (or 0.00833).

The interest rate for borrowing pounds is 5/12 x 5.5% which is 2.29% (or 0.0229)

christopheryaheya says

Thanks Sir, I think it must be a typing error, The question is actually from Kaplan revision Kit. Qn No 20 (LAMMER Plc)

gilbert says

Informative and a good revision run.

christopheryaheya says

Hi sir

Thanks for the lectures, I have one question to ask, Its from December 2008 Exams Question one (BLIPTON), I real don’t know how Project operating cash flow (Nominal) is calculated at the return Phase.

Thanks

John Moffat says

I guess you are clear as to how the real cash flows have been calculated – these are the cash flows ignoring inflation. (If you are not clear about any of them then do post again).

The nominal cash flows are the actual cash flows – i.e. taking account of the inflation (which in the UK is 2.5% per annum.

So…….the first cash flow is $52,000 in real terms, but this is received 2 years after the start of the project and so we need to add on 2 years inflation. 52,000 x (1.025^2) = 54,633

Similarly, the second cash flow is 490,000 in real terms, but is received at time 3 and so we need three years inflation at 2.5% per annum. 490,000 x (1.025^3) = 527676

And so on 🙂

christopheryaheya says

Thanks you very much sir, I will always remain thankful to you

zee90 says

sir is there a lecture on adjusted present value ???

John Moffat says

Yes – it is covered in chapter 12 of the course notes. On the index of lectures it is chapter 11 – the impact of financing.

zee90 says

thankx alot sir

tinashe says

@toobaalvi in as close to a lay man explanation as i can, i understand or treat so i understand working capital to mean its like pettycash. ie you already have taxable income from your sales, and you are told you need to have a buffer cash set aside for incidentals and is readily availed towards the project hence you would have already paid the tax for the same money when you received it as revenue etc. or from the source you raised it with.

The Tutor will answer both of us with a better answer, it just helps me to think of it that way!

John Moffat says

To be honest it does not matter how you think about it provided that you accept that there will be no tax implications, and that (unless you are told otherwise) you will get it all back at the end of the project.

(Although it is not really petty cash – it is money to finance extra receivables and extra inventory. These would not affect the tax liability, and at the end of the project you no longer need to finance extra receivables etc and so you get the money back 🙂 )

abdullah khan says

dear sir whatis difference between ACCA and FIA

John Moffat says

Foundations in Accountancy are a series of exams set by the ACCA that give certificates in basic accounting.

The ACCA Qualification is a full professional accounting qualification for which you have to take 14 examinations.

You can find full details of both on the ACCA website http://www.accaglobal.com

tinashe says

@Cara you meant for Accounting rate of return, thats when you need taxable profit and all. However the Tutor will correct me if iam wrong, it seems P4 (atleast from what i have covered to date assumes that to be carry forward knowledge hence it does not cover that revision, but that does not mean its irrelevant to do it .

2. I also wanted to make an observation on the 20% Fixed Overheads, that statement can be confusing in the exam, i know by now we understand irrelevant vis a vis relevant costs in decision making, and that it then means whether this project is embarked on or not the company will still pay the $1000,000. But once the question says ‘should be absorbed ‘ it tends to imply they arise because of the project and could have been avoided etc. (thats the confusion to watch out for)

The other one is for tax (Payed immediately or one year later ! the later one implies we add for the above example another year 6! as for the (Current prices of inflation! this information are a must to watch out for in the exam!) especially during the reading hours highlight them and scribble what effect they should have e.g whether you start the inflation in year 1 or after year 1.

Otherwise it would indeed be a welcome gift to get such a straight forward question in an exam setting!

John Moffat says

See my answer to Caro below 🙂

tinashe says

thanks this helps a lot.

tinashe says

@Cara i remember thats what my lecture also said for F9 i think then we used to get instances where we had to do an accounting rate of return or something, The syllabus i have covered for P4 i havent seen it touched as a method to use in evaluating investments, In any case when explained we have been mostly made aware of its shortcomings as a basis for appraisal method for a projects. as compared to NPV and IRR.

Admin, I missed the part on why we are not using the 20% Fixed Overheads, i do remember from my previous study though that certain costs are irrelevant in decision making because whether you take on the project or not you still incur them. So is the same logic applied here?!

2. I will practice more examples i have noticed if ever we get an easy question like this one we would be lucky in the exam as the examiner seems to enjoy confusing us by throwing in all concepts in one question esp the compulsory section. Sometimes i really feel, what is important is really not the numbers but understanding the concept enough to apply it in real life situations. As this type of questions can just take too much of the exam time! in future the answer sheets should have the templates in advance! Whew.

toobaalvi says

Hey. I’m anna confirm a single logic. hy orking capital has no tax consequences.?

gaya s. says

Simply a good start of NPV revision 🙂

yiin says

may i know the timing we should start to claim capital allowance?

from my understanding, if we incurred capital expenditure in year 0, we should claim capital allowance in year 1 unless the question state otherwise. But, should i apply the same concept if first year allowance is given in the question?

John Moffat says

time 0 is not a year – it is a point in time.

If you watch the lecture it makes it clear (and if necessary watch the relevant F9 lectures).

However, in P4 do not worry too much about the timing – it depends on assumptions (as does so much of P4). If you state your assumptions then you will get the marks (provided obviously that they are sensible assumptions 🙂 )

conniechew says

helo sir,

can we tear out the formula sheet, the present value table and the annuity table during the exam time, so that its earsier for us to see the rate and save up time,no need to flip the question booklet many times.

thanks

admin says

I suggest you send this question to the ACCA… and please post on opentuition the reply from them 🙂 thanks!

cara says

Hello Sir,

thank you for this lecture , again very well explained 🙂 I have one question in relation to NPV. I just looked in my notes from F9, and my lecturer then ask us in calculation of NPV first include capital allowances in calculation of taxable profit than calculate and deduct tax and than add capital allowances back. So the tax effect is at the end the same as in NPV which you presented. I remember that my lecturer justified this approach because taxable profit which include capital allowances was needed in the calculation of something else, and well I don’t remember now where did we use it. Could you please tell me where we we can use such a profit, and if it will be used in the calculation in P4

John Moffat says

For F9 it does not matter which way you deal with the capital allowances. The answer will be the same whichever way.

For P4, the same usually applies. The only thing at P4 is that in one question it was the case that if there was a taxable loss, then it was made clear that you could not offset it against other profits (and therefore not simply get a tax saving) but that the losses were carried forward.

However, to be honest it is best you leave worries about that until P4 – for F9 it does not matter which way you do it. Whichever way you find the easiest to remember 🙂

springy says

So will it be wrong to include fixed overhead ????

John Moffat says

@springy, see what I have written below in reply to somebody else.

Fixed overheads are only relevant if the total changes as a result of doing the new project.

Dj bee says

@springy,

incemental fixed cost(project related)

step fixed cost

are relent costs….

racheal khondowe says

thanks a good revision of NPV

Ruzz Su says

In the NPV (e.g 1) question we inflated the sales and costs at different inflation rates, which essentially mean that we considered the nominal cash flows. In that case, aren’t we supposed to consider the nominal rate as well which is the real rate inflated at the general inflation?

John Moffat says

@Ruzz Su, Yes – certainly.

However, the nominal cost of capital is the actual cost of capital. Since all the question says is that the cost of capital is 10% we must assume that it is the actual (i.e. nominal) cost of capital. We would always assume this unless we were specifically told the ‘real’ cost of capital.

(Additionally, since the question does not give the general rate of inflation, the again we have to assume that the cost of capital given is the actual WACC i.e. the nominal rate.)

osru says

Thanks very much for your help.

John Moffat says

Fixed overheads are only relevant if the total fixed overheads for the company increase.

If the questions simply says that some of the overheads are allocated to the project, it does not mean that the total expenditure changes.

(The point is that for profit purposes a company change split the overheads between projects any way that they want to, but again, the total cash flow for the company only changes if the total fixed overhead bill changes.)

osru says

hi please can you just confirm why we didnt take into account of fixed overhead cost?

thanks

chaga says

@osru, Listen from 13.18 to 13.50