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Good day Mr. Moffat.
I have a question on the solution to question 5b referred above. From year 5 to perpetuity a constant net cash inflow has been considered. Can we assume that the initial investment can continue to generate cash flows in perpetuity without any further costs. Tax allowable depreciation ends in year ten suggesting that the life of the asset is plus or minus ten years. I am worried that in perpetuity the asset will end up not producing anything, if no additional investment is made.
May you explain Sir.
Firstly, given that they have paid for the initial investment in the new facility of $4M, there is no reason why there should be any extra costs (other than the yearly conversion costs and fixed costs given in the question, which have been dealt with in the answer). If any additional investment were needed then the question would have said so.
Secondly, as regards the tax allowable depreciation is concerned, that depends on the rules of the particular country and the type of investment. Here we are told in the question that it is straight line over 10 years, but that certainly does not mean that the investment will last for 10 years – it could be shorter or (as in this question) it could be longer – just as it is with accounting depreciation. They will be allowed depreciation on $4M in total, but how it is allowed depends on the rules of the state (which for exams, will be given in the question). I assume that you have already taken Paper F6 in which case you will know the tax rules for whichever country’s tax exam that you sat, but in F9 you are always told the relevant rules.
My free lectures on investment appraisal with tax will help you. The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
Thank you for the response Sir.
I understood everything about the question and the solution. My question is how practical is it to say an investment in the new facility can earn cash flows in perpetuity without any service costs or maintenance costs? I think this is not practical. For the purpose of passing the exam, I am fine but I am worried about the practicability of the question. I think its not all about passing the exam.
I thank you for your lectures which are straight to the point especially on CAPM and MM, Investment appraisal and alternative receivables management.
I don’t know why you say that it is not practical. I do agree that in practice there will be maintenance costs etc. needed, but these are presumably included in the variable and fixed costs given in the question.
In practice, all the costs and revenues are only ever going to be estimates. The one thing that is impractical is the idea that the project will last for ever – that is clearly always impossible. However, it is really assuming that it will last for a long time – if it is more than 20 years or so, then the discount factors become so small as to approximate to a perpetuity anyway.
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