December 2010 Question 2 to understand my query on depreciation to maintain operations?

Ssomekasu14y ago

To,
Mr.Johnmoffat
Sir
Thanks for your reply, but I feel I am unable to express my doubt, that's why I am posting with an example.
This is to my further query to question posted previously on "Depreciation is the same amount as needed to maintain operations.?"
December 2010 Question 2 relevant portions
Plant and machinery used in the manufacture will cost $3 million
Fubuki Co’s tax rate is 25% per year on taxable profits. Tax is payable in the same year as when the profits are earned.
Tax allowable depreciation is available on the plant and machinery on a straight-line basis. It is anticipated that the value attributable to the plant and machinery after four years is $400,000 of the price at which the project is sold.

So depreciation is 30-4/4 =6.5

In part 2 (a) working 1
Profits
Less allowances ie. 6.5
Will give taxable profits
Deduct taxes
Now we have to add back depreciation to get cash flows, but examiner has not done it. This is my question.(case 1)
Or as stated by you the working 1 will look like this
Profits
Deduct taxes
Add tax benefit on depreciation allowance i.e., 0.28*6.5 = 1.82 (case 2)

In answer to part b about assumptions made examiner states that
6. It is assumed that the annual reinvestment needed on plant and machinery is equivalent to the tax allowable
Depreciation. And he further states that Assumptions 4, 5, 6, 7 and 8 are standard assumptions made for a question of this nature.
So my question is if we make above assumptions
In case 1 we don’t need to add back depreciation, hence examiner is right, but if we don’t assume as examiner we need to add back depreciation to get cash flows.
In case 2, if we don’t assume as examiner we need to add back tax allowance to get cash flows.
I am right or wrong,

Regards
somayajulu

John MoffatTutor14y ago#1

The examiners answer is correct.

There are two ways of dealing with tax. Either work out the taxable profit (cash flows less depreciation) and then get the tax directly. Or calculate the tax on the operating cash flow (the 'cash' profit before depreciation) and then calculate the tax saved on the depreciation. Either way is allowed and both ways give the same answer - in the answer to this question he has used the first approach.

If you look at the cash flows for year 1, the operating cash flow is 690 (he has called it profit, but it is not - it is the 'cash' profit, i.e. the profit before depreciation).

In his working 1 he had then subtracted the depreciation of 650, calculated the tax (10) and then put the tax cash flow under year 1. He does not need to add back depreciation anywhere because the 690 is the cash flow and is therefore already before depreciation.

If you had used the other method, you would have said that the tax on the operating cash flow was 172.50 (25% x 690) and put this under year 1 as a cash outflow. Then you would have calculated the saving on depreciation as 162.50 (25% x 650) and put this under year 1 as an inflow. The net effect of these two line would have been an outflow of 10 (172.5 - 162.5) which is the same as he has got.

PS I don't always check this forum - use the Ask the Tutor forum in future.

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