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Hi, can you please clarify that which of the following is correct way to treat capital allowances?
We take the capital allowances % , apply tax rate to that resultant figure and then deduct it from operating profit/cashflow before tax?
I have also seen it treated differently I thin where the figure deducted was %capital allowance i.e without applying the tax rate?
And finally do we subtract it from operating profit or add it back to profit after tax? Since both will give a different profit figure?
Thanks a lot.
sameed:
Let me explain with an example.
Suppose the operating profit was 100, the capital allowances were 20, and the tax rate is 30%.
One way is to calculate the taxable profit 100 – 20 = 80. The calculate the tax: 30% x 80 = 24. Then to calculate the cash flow: It is not 80 – 24, because the capital allowance is not a cash flow, it was only there to calculate the tax, so we need to add it back and we get 80 – 24 + 20 = 76.
The other (safer and easier way) is to take the operating profit (100), calculate the tax ignoring allowances (30% x 100 = 30), then separately calculate the tax saved from the allowances (20 x 30% = 6).
These are all cash flows so the net result is 100 – 30 + 6 = 76.Both ways give the same answer, but the second way is easier and safer in the exam.
Ok thanks a million, one more thing what is difference between capital allowance and tax allowable depreciation? Are they the same?
Hi. When calculating cash flow from operations, is capital allowance and depreciation both added back to Net Income?
Thanks
Yes, because neither is a cash flow.
However for most (but not all) questions it is easier to calculate the tax on the operating profit (after adding back depreciation) and then calculating separately the tax saving from the capital allowances.
If you are not clear about this then watch my free Paper F9 lectures on investment appraisal with tax (because this is revision of F9). I explain the rules about tax and how we deal with it.
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