- This topic has 6 replies, 3 voices, and was last updated 4 years ago by
.
- Posts
Hi John,
I hope you are well.
I am struggling very much with the TAD portion of the test your understanding number 3 (Blade’s Company) in Chapter 7 of Kaplan’s study text. In the answer solution in the book, they are directly bringing in the tax portion of the TAD into the cash flow. The issue is that in the first year, if we do the normal way of first deducting TAD to get the taxable profits, there is actually a loss which normally should be carried forward. And then TAD should be added back.
In this case, no deducting or addition of TAD is done and directly the tax portion is being brought in.
Only thing which I can see of significance is the statement “The firm is certain that it will earn sufficient profits against which to offset these allowances”.
I hope my explanation makes sense. Could you guide me please? THank you!
I do not have the Kaplan Study Text.
However, the reason is indeed the last statement that you quote. Even if that statement was not there we always assume (as we did in Paper FM (was F9)) that the company is already making profits and is therefore already paying tax. Therefore if the new investment makes a ‘loss’ this ‘loss’ simply reduced the existing profits of the company which results in less tax being paid by the company. So the ‘loss’ does not get loss relief but just saves tax that the company would otherwise be paying.
The one exception to this, as I explain in my free lectures, is that if it is an investment in a foreign country (as it often is in Paper AFM), then if there is a loss then the tax payable in the foreign country that year is zero and the loss is carried forward to reduce the taxable profits in the following year(s).
Hi John,
I’m facing a similar issue and hope to clarify Talal’s issue above with an example. I believe the main issue here is the different methods used for treating the tax allowable depreciation:
i) deduct TAD from the operating cash flow to identify taxable profit, calculate tax payable based on taxable profits and finally add back the TAD
ii) calculate tax payable based on operating cash flows, add the tax relief portion from TADPlease allow me to illustrate the above with a worked example, let’s assume a 2 year project (ignore initial investment outlay):
Operating cash flow = $100 in years 1 and 2
TAD = $120 in year 1, $50 in year 2
Tax = 30%Using method 1:
We would have a $20 loss in year 1, which is carried forward to Year 2 and hence the tax payable for year 1 would be 0. Net cash flow in Year 1 (after adding TAD) = $100.In year 2, we would have a taxable profit of $50, offset with the $20 loss from year one would give us a tax payable of $9. Net cash flow in Year 2 (after adding TAD) = $91
This gives us a total cash flow of $191 over 2 years.
Using method 2:
In year 1, we would have operating cash flows $100, less tax payable $30, add tax relief $36 = $106In year 2, we would have operating cash flows $100, less tax payable $30, add tax relief $15 = $85
This method also gives us a total cash flow of $191 over 2 years.
However, the cash flow for the individual years (Year 1 and Year 2) differ between the 2 methods and hence, when discounted would give us different NPVs.
Could you advise which is the preferred method for this exam?
Thank you!
But I have explained this in my reply to Talal.
Individual projects do not get loss relief. The company pays tax on its total profit and there is only any loss relief if the company as a whole makes a loss. This is not a ‘preferred method’ this is normal tax rules.
If a company is currently making profit and therefore currently paying tax (which is what we normally assume to be the case) then if they do a new project that makes a loss, then what is really happening is that it reduces the profit that the company is currently making and therefore saves tax. There is no loss relief for anything.
I explain this in my free lectures for both AFM and for Paper FM (because it was the same in Paper FM).
Please read my previous reply again (and watch my free lectures).
Apologies, John. I somehow missed your initial reply as I was scrolling through. This makes perfect sense, thanks a lot for your response!
- The topic ‘Kaplan Study Text – TU3 of Chapter 7 – Adjusted present value’ is closed to new replies.