June 2012 q1 -METIS

Note 5 says that accounting depreciation is a tax allowable cost. It will decrease the tax bill, but it is not a cash flow so has to be added back.

If you are going to use NPV you must ignore interest flows and any tax relief on those flows. Discounting handles interest.

For 2010, the profit before interest and tax is $31,200. Ignoring interest, this will be taxed at 30%, leaving profit after interest of $21,840. (Note, depreciation is allowable for tax)

However, the depreciation amount of $120,000 is not a cash flow (depreciation never is), so the free cash from the operating cash flows is $21,840 + 120,000 = $141,840

I would ignore that – it is a really peculiar, once-off calculation and it is not worth investing valuable time in.

Look instead at the tutor note right at the end of the question.

Sir, two things:

Firstly, why do we use the cost of capital as WACC whereas we have the mix of capital (250k equity and 350k debt) and their relative costs to calculate WACC, is it because the question says ‘Overall Cost of Capital’ as a synonym for WACC, “overall” being the key word here?

Secondly, Why does the marking scheme and the revision kit answer both have a table calculating PAT for all three years where the first two years are clearly not relevant anywhere in the question, am I missing something here?

That’s the thing sir, for the latter part, the PBIT as needed for NPV is provided in the question and tax is being calculated on PBIT too there, so all the figures for 20X0 and 20X1 in the table calculating PAT are completely superfluous…