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Hi, for Section A (1), in the sample answer, under (Appendix 1 (Part (b)(i)), please may I know why the figure for tax-allowable depreciation in year 4 is -$12,250,000, if the machinery is expected to be sold for $7,000,000 at the end of the project?
Thank you.
It is the balancing allowance in the final year, which is the difference between the tax written down value after three years of $19,250 and the sale proceeds of $12,000.
Do watch my free Paper FM lectures on investment appraisal with tax, because this is pure revision from paper FM.
Also, for the value of Honua Co offer, the call value is $10,205,640 and the put value is $2,409,899. Please may I know the rationale of using the put value as the final value of Honua Co’s offer? What will happen if I only use the call value? Must the Put Call Parity Relationship be taken into account?
Thank you.
It is a put option because they have the right to sell the project.
To get the value of a put option we always need to calculate the value of a call option first and then use the put call parity formula to get the value of the put option. If you only calculated the value of a call option you would get some marks, but not all of them because it is not a call option.
This is all explained in my free lectures on real options.
Meanwhile, please may I know why the put option of Jigu Project is not calculated?
Thank you.
Partly because you are not asked to calculate it – only to explain how Pa was calculated, but also because the option is for a new (follow-on project) which is a call option.
By the way, for Q3 (b), under the free cash flows of Poynins Co, the discounted investment in assets from year 4 onwards is calculated as $25 / 0.09 x 0.772 = $214.5.
Please may I know what does it mean for the $25 to be divided by 0.09 (cost of capital)?
Thank you.
It is a perpetuity and we always discount a perpetuity by dividing by the appropriate interest rate.
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