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Dear John sir,
The investment in NCAs figure which the examiner has found out as $44.6m is absolutely hard to understand! its such an esoteric calculation! I seem to be getting too confused now. In most questions that i have solved so far, every time it has been said that ‘investment in NCAs is going to increase by say 4% or 5%, then the amount we deduct this year, is= past yr’s investment multiplied with (1+x%). That means that the co. this yr has to spend an amount equal to last year plus some additional depending on % of growth. And not just deduct the growth and leave the calculation, it has always been (1+x%).
However, here it is strange. After finding out the year end NBV, we compare it with the investment needed(110×1.04), and then only the shortfall is spent. Which is really riling and so much contradictory to what we have done so far!
Can you please guide me sir, am absolutely crestfallen, now and seem to be losing all hope of cracking this subject.
You are confusing it with operating expenses where there is an expense each year. If there is inflation then the expense increases each year.
Without inflation you would not expect to be spending the same amount each year on non-current assets. What you might expect it that they need to spend more each year in order to keep the total of the non-current assets in line with inflation (and the question does say they in order to maintain productive capacity they need “sufficient investment to increase the net book value by 4%”. Given that it is $110 million at the start, to increase it by 4% means spending an extra 4% in order to bring the total up to $110 x 1.04. So the extra needed is 4%.
so sir whenever we are told that investment is likely to rise 20% or x % for that matter, what is the examiner trying to allude at? that the entire investment of (1+20%) is additional cash outflow or just 20% is INCREMENTAL CASH OUTFLOW?
Assuming that you are referring to either the initial capital investment or to the investment in working capital, then it means just the extra (incremental) 20%.
Good day sir, i have a doubt related to arthuro co. Since they have given cost of asset ($35m), accumulated depreciation($24.6), so we are able to find the residual value($10.4) and from the profit amount($5.9m) given in the question we can find the scrap value($16.3m). Thus my doubt is why didnt we find for its balancing charge amount (profit x tax) to place it in the FCFE statement?
It is because note 3 of the question says that the operating profit is after depreciation and the profit on disposal, and that the depreciation is allowable and the profit on disposal is fully chargeable to tax.
sir, i am actually still feeling confused. Capital allowance is tax allowable depreciation right? Usually for finding dividend capacity we will use FCFE format to do it which means depreciation will be deducted before finding the profit before tax, however we need to add it back to find the net cash flow. So for this question the operating profit already deduct the depreciation. Balancing charge is not deducted because balancing charge is depreciation which is deducted to get the operating profit? As my understanding (cost-acc depreciation=residual value < scrap value, we take the profit value x tax)= balancing charge.
i have some knowledge gap in capital allowance, balancing charge and balancing allowance. It will be helpful if sir can guide on this. Many many thanks in advance.The tax is calculated on the operating profit after charging depreciation and (as per note 3 of the question) after including the profit on the sale of NCA’s.
However since the depreciation and the profit on sale are not cash flows, we then do add back the depreciation and subtract the profit on sale in order to arrive at the net cash available for dividends, and this is what has been done in the answers.
Any balancing charge or allowance is irrelevant for this question because of what is written in note 3 (i.e. that the profit on disposal is fully chargeable for tax).
(In full NPV questions, knowledge of the capital allowance rules and the balancing charge or allowance is important and if you are unsure then look back at the Paper FM lectures on investment appraisal with tax where it is all explained. However this is not relevant for this particular question because of what I have written above.)
Thank you very very much sir for taking your time to explain to me in detail. Now i have a clearer image about it. 🙂
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